There is no free lunch - especially when it comes to finance government expenditure and revenue gap. On a good note, fiscal inflationary borrowing from central bank is and expected to remain below the ceiling of September end level of Rs 1290 billion, the dark side is that the onus of funding is tilting more towards commercial banks as foreign funding is elusive. SBP feared that this trend is to continue.
"In our view, banks would be happy with this, as it reduces their risk-weighted assets, which is especially important given the increase in NPLs.... Commercial banks appear almost to have given up their role as financial intermediaries", SBP second quarterly report highlighted.
The reading between the lines is that the taxpayers are financing the windfall profits of commercial banks. This is a profound implication and needs to be resolved by a combination of regulatory and legislative measures. Some argue that the banks' tax rates are to be increased, however, this or status quo could come under the domain of policy inaction. State Bank ought to work on to pass on the benefit to banks' deposit holders to squeeze spreads and apply limits on fiscal lending to force banks by moving away from the lazy behaviour of risk free lending to finance SMEs, agriculture sector and the corporate.
Unless that happens, private credit will be cornered further. "...which is not a good omen for economic growth and employment generation", SBP aptly pointed out. The legislative measures required are to enhance the tax base, have tax enforcement reforms and restructuring of public sector entities. "Increasing the tax base is without doubt the toughest structural reform to implement, and the one that needs the greatest political will", the report summarised the hindrance to the growth trajectory.
Nonetheless, it appreciated the token short term austerity measures taken by the fiscal mangers. "We remain cautiously optimistic about progress on the fiscal side, as shown by the recent fiscal measures to reduce the gap by Rs 210 billion this fiscal year.", it added expecting fiscal deficit to hover around 5.5-6.5 percent of GDP in FY11.
The report also acknowledged the improvement in external accounts owing to high export oriented commodity prices ie cotton and rice. This coupled with record remittances, disaster relief and coalition support funds kept the external account comfortable. However, it warned "Going forward, pressures could build on the external sector in the last quarter of FY11 (April to June 2011), which could be compounded by the recent trajectory in international oil prices.". The SBP showed satisfaction on agri sector growth despite the devastating floods and expects the wheat crop to meet its target.
The SBP was nonetheless sceptical on agri productivity enhancement and feared that gains could not sustain once international prices recede and had not been possible in the absence of higher administrative prices. But the bone of contention is the slacked performance of the manufacturing sector." the acute energy shortage (especially gas) and the prevailing political uncertainty have hampered productive activity... As the country moves into summer, the power shortage is likely to get worse, while the gas situation should improve as household usage for heating eases", the report noted.
Another implication of fiscal indiscipline is cuts in PSDP. "Hence, economic activity in construction (and its affiliated sub-sectors) has been less than anticipated, and is likely to stay this way." State Bank added. The masses are affected most by inflation which is due to a combination of hike in administrative prices which include retail fuel prices, power tariffs, wheat support price etc and non-administrated prices. The SBP has little control on administrative prices, however, fiscal slippage and it's financing from central bank and monetary policy measures are instrumental in the direction of non-administrative prices.
"More simply, the link between SBP financing and non-administered prices is becoming more visible. Unless, monetary policy can credibly limit government borrowing from SBP, it will be difficult to change inflationary expectation", the report added. The SBP is clear that two factors the external account situation and the government borrowing from SBP will determine the direction of inflation and the biggest risk to both is persistent high international oil prices.
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