Monetary policy statement

Reproduced below the Executive Summary of Monetary Policy Statement announced by State Bank of Pakistan Delays in crucial economic reforms have increased challenges for the management of the economy. Despite high interest rates, the fiscal deficit and borrowings from the banking system is continuing to stoke inflationary pressures. This is impeding economic recovery and increasing the debt burden of the country.
However, an improved external current account and stable financial markets allow for some optimism. Under these challenging circumstances, a proactive monetary policy is necessary but not sufficient to tackle high and persistent inflation. Inflationary pressures that were already high at the beginning of FY11, and have remained at elevated levels during H1-FY11. In December 2010, year-on-year CPI inflation was 15.5 percent while its average for H1-FY11 stands at 14.6 percent.
Not only did the contributing factors of inflation continued to prevail in H1-FY11, the economy also experienced an additional shock in the form of unprecedented devastating floods. Despite some adjustments in the prices of electricity and gas, the larger issue of energy shortages remains unresolved.
This is contributing to the under-utilisation of existing productive capacity and discouraging new investment in the economy. Consequently, the aggregate demand and supply gap is still large enough to push inflation further. Surging international food and commodity prices are also playing a role in intensifying expectations of rising domestic inflation.
Thus, the revised projection of average CPI inflation for FY11 falls in the range of 15 to 16 percent, along with high probability of double digit inflation in FY12. To bring inflation under better control, the critical measures would be fiscal consolidation and reduction in fiscal deficit and government borrowings from SBP. These measures would support SBP's efforts to contain monetary expansion and thus ease aggregate demand pressures.
After a continuous rise in government borrowing from SBP since the beginning of FY11, there seems to be some respite on this front. The outstanding stock (on cash basis) of these borrowings, which had increased to Rs 1500 billion by mid-December 2010 from Rs 1171 billion at end-June 2010, has reached close to Rs 1277 billion by 25th January, 2011. This is an encouraging development and, if sustained, could help in restricting excess money growth and moderating expectations of high inflation.
At the same time, due to an improvement in the external current account, the increase in Net Foreign Asset (NFA) has contributed to maintaining year-on-year reserve money growth at 16.6 percent. Thus, while there is a favourable compositional change in reserve money, the growth of its Net Domestic Asset (NDA) component still needs to be curtailed to reduce inflation.
The external current account shows a surplus of $26 million during H1-FY11, which is a marked improvement over earlier projections. Robust export earnings of $11.1 billion are the main reason underlying this encouraging development. Higher international prices of Pakistan's exports like textiles and rice were helpful in this regard.
Specifically, of the $1.8 billion incremental increase in exports in H1-FY11 (over H1-FY10), about $1.4 billion is due only to the increase in prices. Assuming that this trend continues in H2-FY11, export growth in FY11 is projected to be 15 percent. Imports, which grew by 10.1 percent in H1-FY11, are projected to grow by 12 percent in FY11, primarily on account of rising international commodity prices, especially oil.
Further support to the external current account in H1-FY11 was provided by strong inflows of remittances, $5.3 billion, and the disbursement of Coalition Support Funds (CSF), $743 million. Consequently, even with modest direct and portfolio investments, and despite delays in disbursement of official loans, SBP's foreign exchange reserves have increased from $13 billion at end-June 2010 to 13.5 billion at end-December 2010.
This build-up in reserves and thus NFA is one of the factors responsible for stability in the financial markets, despite increased borrowings from the scheduled banks by both the government and the private sector, especially in Q2-FY11. However, given a decline in financial inflows, the financing of even a smaller external current account deficit for FY11 (projected at 1.5 percent of GDP) could pose challenges for an adequate build-up of foreign exchange reserves.
The credit availed by the private sector during Q2-FY11 was Rs 211 billion as compared to Rs 199 billion in the corresponding period last year. This trend was despite a declining growth in Large-scale Manufacturing (LSM) and is largely attributable to the rising cost of inputs. This pickup in private sector credit may slow down in the coming months as it was mostly due to seasonal working capital requirements.
The recourse of the government to the banking system, on the other hand, is likely to increase in H2-FY11. This is both because of the widening gap between revenues and expenditures in the fiscal accounts and subdued financing available from external sources; with only Rs 47 billion having been realised in H1-FY11.
Tax collection of Rs 661 billion by the Federal Board of Revenue (FBR) during H1-FY11 shows a growth of 13 percent only. At the beginning of the fiscal year, a growth rate of 26 percent was envisaged to achieve the full year target of Rs 1667 billion.
Thus, a shortfall in revenue appears quite likely, especially with the postponement of revenue enhancement measures. At the same time, rising expenditures, primarily owing to subsidies for energy, food items (like wheat and sugar), cash transfers, and security related activities, further indicate difficulties that lie ahead.
At the beginning of the fiscal year, the announced fiscal deficit target was Rs 685 billion (4 percent of GDP) that was revised to Rs 812 billion (4.7 percent of GDP) in the aftermath of the floods. The provisional data from the financing side of the budget, however, suggests that the deficit has probably already beginning to touch Rs 500 billion by the close of H1-FY11. Thus, even meeting the revised target would be a challenge in the absence of fiscal reforms.
These fiscal developments have two implications. First, the overall demand for money is unlikely to subside, which indicates high aggregate demand relative to current productive activity. A concurrent increase in banking system deposits through a decline in currency in circulation would be helpful in meeting this demand without additional pressure on market interest rates. Second, the private sector is likely to be squeezed out, which is contrary to what the economy needs for the revival of investment and growth.
It is important that the government spells out a clear and coherent strategy to limit fiscal slippages. This is all the more important given that the proposed reforms in the GST along with other tax measures have been postponed. Moreover, in January 2011, the government reversed the decision of increasing retail prices of petroleum products.
Apart from adversely affecting revenue collections and increasing expenditures on subsidies, these actions have made it difficult to raise external resources for budget financing. To understand SBP's policy stance for H2-FY11, it would be useful to assess these developments in the backdrop of three successive 50 bps hikes in the policy rates that have already been announced in this fiscal year.
In providing its rationale, SBP had primarily focused on high and persistent inflation that was being exacerbated by a structural fiscal deficit frequently financed by government borrowings from SBP. It was highlighted that fiscal problems were not only undermining the monetary policy stance but also carrying the risk of adversely affecting external accounts.
The direct link between the pace of government borrowings from SBP and the expectations that individuals and businesses formulate about future inflation was also emphasised. In SBP's view, these expectations have been a major contributing factor in pushing core inflation up, which often gets less attention than supply side factors like fuel and food prices.
While the underlying structural reasons for this policy stance have not changed significantly, there are three sources of comfort. First, SBP anticipates that the current shift away from SBP financing will be consolidated since an understanding has been reached with the government that it will restrict its borrowings from the SBP to below the end September stock of Rs 1290 billion.
Second, an external current account surplus in H1-FY11 is somewhat rare in Pakistan and is a marked improvement over earlier projections. This indicates that the risk of fiscal problems slipping into external account has not materialised so far, thereby providing an opportunity to address the persistent fiscal issues.
Third, SBP is optimistic that the recent multi-partisan efforts will improve fiscal revenues and curb current spending (one-off and continuous). Further, candid disclosure by the government of the impending crisis in case of failure to reinvigorate fiscal reforms cannot be brushed off lightly. Under these exceptional circumstances, it is expected that tangible steps will be taken to steer the economy back on track.
The likely positive outcome of these developments has been incorporated in monetary policy considerations, while not ignoring the existence of a monetary overhang. SBP believes that, on balance, this provides a window of opportunity and the focus should be on subsequent developments.
SBP is also aware of the delicate balance that needs to be struck between risks to inflation and economic growth and therefore has decided to keep the policy rate unchanged at 14 percent for the time being. The future course of policy action will be contingent upon expected progress of key areas of concern to SBP.