Wait-and-see policy of SBP

The latest Monetary Policy Statement (MPS) was issued by the SBP on the 8th of March. Since the Russian-Ukraine war situation remains fluid and it is not clear what the sustained impact on commodity prices will be in coming months, the MPC (Monetary Policy Committee) assesses that the outlook for the rate of inflation in the country and the size of the current deficit is uncertain.

As such, the MPC has noted that it ‘was prepared to meet earlier than the next scheduled meeting in late April, if necessary, to take any needed timely and calibrated action to safeguard external and price stability’. Meanwhile, the policy rate has been kept unchanged at 9.75 percent.

However, there are a number of observations by the MPC that need to be examined in light of the observed trends. First, the MPC apparently failed to recognize that even prior to the Russia-Ukraine war, commodity prices had maintained a rising trend, which has accelerated after the onset of the war in the last week of February, but hopefully of a temporary nature.

The price of crude oil (Brent) went up from $73 per barrel in December to $83 per barrel in January. If this increase persists this alone will add $2 billion to the annual import bill. Similarly, the price in January in relation to a month earlier is higher of palm oil by 6 percent, of wheat by 3 percent, of cotton by 10 percent and of coal by 16 percent. This upward pressure, which is likely to continue on the level of imports, has largely been ignored by the MPS. It will impact adversely on the current account deficit and the price level in the country. Policy action was already required to limit this deficit which has already reached the all-time peak level in seven months of $11.6 billion.

Contrary to this development, the MPS has argued that the extra-ordinarily high current deficit of $2.6 billion in January largely reflected lumpy imports of oil, vaccines and other items financed through loans and credit. There are problems with this view. First, imports of oil and vaccines fell by over $800 million as compared to their imports in December. Second, if financing was readily available then why was there a large balance of payments deficit of $1087 million in January?

The MPC says that inflation would have declined further to below 12.2 percent if it were not for abnormal increases in prices of a few perishable items. The SBP needs to appreciate that the rate of inflation, as measured through the rate of change in the CPI, significantly understates the rate of inflation in the country.

There are two primary sources of understatement. First, the rate of increase in housing rents is significantly below the likely underlying rate. There is an acute shortage of housing in the country of up to 4 million housing units. Also, the rate of increase in prices of construction input items in urban areas, for example, was almost 11 percent in February. Yet, the PBS reports that on a year-to-year basis the rise in housing rents was only 6 percent in February. The weight of rent in the urban CPI is the highest at over 19 percent. It is likely that this has led to an understatement of the rate of inflation by close to one percentage point.

Second, the electricity price does not include the fuel adjustment charge which was almost four times as large in February 2022 as compared to February 2021. Overall, there is need for the SBP to carefully review the inflation rate estimation methodology adopted by the PBS. The underlying rate of inflation is probably significantly higher than that reported by the PBS (Pakistan Bureau of Statistics).

The MPC also continues to show guarded optimism about the GDP growth rate at 4-5 percent in 2021-22. This is based on 5-6 percent growth rate in the large-scale manufacturing, following the rebasing between October and December, and earlier to a big jump in cotton output. With the earlier base year of 2005-06 the growth rate of the large-scale manufacturing sector is only 1.5 percent in the same period of the second quarter of 2021-22. Here again, there is need to investigate why the change in the base year from 2005-06 to 2015-16 has led to such a big change in the growth rate.

The SBP has readily adopted the new GDP estimates with the year 2015-16 as the base year. The GDP at current market prices is higher by as much as 16.3 percent in 2020-21 over the estimate with 2005-06 as the base year. The methodology adopted by PBS for rebasing was very ad-hoc in nature. It should have been preceded by a census of establishments and household production units as was done prior to the rebasing exercise in 2005-06. This is not the case and proper sizing especially of the informal sectors is not possible without the census. Also, the National Statistical Council has not yet endorsed the new GDP estimates.

The SBP has perhaps readily accepted these estimates because they imply lower a debt to GDP ratio and indicate a more sustainable financial position of the country. For example, the external debt to GDP ratio has come down due to the rebasing significantly from 40.2 percent to 34.6 percent. The question is whether international agencies like the World Bank and the IMF will accept the new GDP estimates?

There is yet another optimistic statement by the MPC. It is assumed that the new relief package announced by the Prime Minister, with reduction in prices of motor spirit and HSD oil and electricity tariff and the commitment to hold them constant up to June, will not add to the fiscal deficit due to other offsetting savings or incremental revenues.

The compensating mechanisms identified by the Ministry of Finance are largely illusory in nature and unlikely to be realized. Under plausible assumptions the cost of the relief package from March to June is in the range of Rs 350 to Rs 400 billion. A large part of this cost is likely to contribute to a bigger budget deficit.

Finally, the IMF seventh review is on-going. There have been numerous deviations from the structural benchmarks and prior actions. For example, the monthly enhancement in the petroleum levy by Rs 4 per litre has not been adhered to. The commitment to not offer any new amnesty scheme has been violated. The electricity tariff should have been enhanced, but it has been reduced instead. The probability does not look high that the review will be successfully completed.

Therefore, the wait-and-see attitude of the SBP is likely to be transformed shortly, with higher rate of inflation, larger current account deficit and less inflow of foreign loans in the absence of an operational IMF programme. We hope that in these difficult circumstances the newly autonomous Central Bank will rise to the occasion and succeed in restoring economic stability in the country by judicious use of the policy instruments available to it.

(The writer is Professor Emeritus at BNU and former Federal Minister)

Copyright Business Recorder, 2022