MPS - Safety first!

The graph on the title page of monetary policy statement summarized the sorry state of the country's monetary affairs; particularly within the banking system. Ever since 2008, foreign inflows have been on a steep decline and government budgetary borrowing has piled higher. The gap is widening and since the start of this fiscal year emerged another variable; SBP open market injection, to keep the liquidity afloat.
What can be done by engineering pricing tools when the private credit is at bay owing to capacity constraints emanating from energy woes, increasing reliance of government on banking system and net foreign outflow.
The government must act now against liquidity constraints, before the problem becomes chronic. It must spur domestic savings and provide incentives to boost foreign inflows.
The objective of monetary policy is to strike a delicate balance between containing inflation and generating employment. With inflation pressure receded in the first half of this fiscal and attainment of full year target of inflation at 12 percent appearing plausible; SBP swiftly slashed the policy rate by 200 bps to 12 percent in first two policy reviews of the current fiscal, keeping real interest rates close to zero.
Now with the resurgence of inflationary pressures in the second half owing to upward revision in energy prices, high international oil prices, depreciation in rupee dollar parity and more fiscal financing, dependence on banking system; a cautious approach is warranted.
Monetary aggregates are depicting the same. At first glance, there are liquidity constraints - reserve money expanded by just Rs147.5 billion during July - February FY12. "The Net Domestic Assets (NDA), which largely constitute SBP's liquidity operations and government borrowings from SBP, expanded by Rs333 billion. The Net foreign Assets (NFA), depicting the external sector pressures, contracted by Rs185.5 billion. Given its strong correlation with inflation, the resulting increase in the NDA to NFA ratio, to 3.9 from 2.2 on 30th June, 2011, is not a welcome development", asserted MPS.
It is pertinent to note that SBP injection through OMO is at abnormal high levels - "The outstanding amount of liquidity injections is Rs326 billion. This is significantly higher than normal SBP operations and has developed characteristics of a permanent nature, which poses risks to inflation outlook. Despite these risks, SBP continues to inject liquidity to ensure smooth functioning of the payment system and avoid financial instability" warned the central bank.
Falling foreign reserves make the country vulnerable to a balance of payments crisis. "Thus, unlike FY11 when SBP was building foreign exchange reserves and generating rupee liquidity, a weak balance of payment position in FY12 has become a source of liquidity drain," MPS added.
And more repayments are coming! USD1.1 billion are scheduled to be repaid to the IMF in 2HFY12. "This will make the task of managing foreign exchange reserves even more challenging. SBP's liquid foreign exchange reserves had already come down to $12.2 billion by 8th February, 2012 from $14.8 billion at end-June 2011. Similarly, the rupee-dollar exchange rate is under pressure and has depreciated by 5.2 percent in FY12 so far", SBP lamented.
Investment is at a record low level. There is virtually no credit being extended for fixed investment in the private sector, rather it contracted by Rs12 billion in the first half. "This reinforces the view that the primary factors for low credit demand for fixed investment remain the infrastructural bottlenecks such as energy shortages, unfavorable law and order conditions and uncertain political environment.
In addition, the utilization of installed capacity in major industries is considerably low and continues to decline, which explains low investment in the economy. The declining investment was one of the key considerations for SBP's decision to ease its monetary policy stance in H1-FY12, given that inflation was expected to fall within its target for the year", MPS explained.
Energy issues are not only hindering investment directly but also adding to the fiscal woes via the devil of energy circular debt and exerting inflationary pressures by using pricing tools to plug in the difference in cost and revenue within the energy chain.
Reforms in energy sector can go a long way to achieve the medium term budgetary framework targets. Apart from energy the tax revenues of federal government must improve to create room for private credit and contain inflation. Non tax revenues such as CSF flows and proceeds from 3G licenses are imperative for containing fiscal deficit in FY12. CSF is a political sensitive issue while SBP governor is optimistic on getting USD800-1000 million trough 3G licenses within this fiscal year.
These flows are important for both containing the fiscal deficit below 5.5 percent of GDP and current account deficit around 2.5-3 percent of GDP.
Fiscal issues cannot be overemphasized as these can plague the overall economic and business activities within the country. "If fiscal issues are not addressed in time, the strong inter-linkages between fiscal vulnerabilities and financial stability tend to spill over to other sectors, disrupting productive economic activities," SBP warned.