Cut in policy rate

After keeping the policy rate unchanged at 9.5 percent in the last two monetary policy decisions in February and April, 2013, the State Bank of Pakistan (SBP) has finally decided to reduce it by 50 basis points to bring it down to 9 percent with effect from 24th June, 2013. However, it has recognised that the reduction was not essentially due to some major fundamental changes in the macroeconomic indicators but due to its own assessment with regard to the factors affecting the monetary policy formulation and change in the economic outlook after the elections. On its part, it has decided this time to place a higher weight to declining inflation and low private sector credit related risks to the balance of payment position.
On the political front, there has been a discernible positive change in sentiment post-May, 2013 elections. According to the surveys conducted by the SBP, there was a considerable improvement in consumer confidence, expected economic conditions and inflation expectations while absence of foreign financial inflows and high fiscal borrowings remained formidable economic challenges.
SBP appears to be quite satisfied with the present rate of inflation, with the CPI inflation for FY13 expected to be at least two percentage points below the target of 9.5 percent but is not so sure about the behaviour of prices next year due to increase in GST by one percentage point, changes in tax structure for some goods and services and phase-wise upward adjustment in electricity tariff. There is a risk that average inflation for FY14 could exceed the target of 8 percent for the year. At present, however, a declining inflationary trend and below potential GDP growth make a case for further reduction in the policy rate. High real interest rates - policy rate minus expected inflation - are not helpful for supporting private investment in the economy. SBP is very clear that current balance of payments position and structural imbalance in the fiscal accounts suggest vigilance. While the current account deficit is expected to remain at 1 percent of GDP for FY13, there was a net capital and financial outflow of dollar 143 million during the first eleven months of the current fiscal year. The pressure on foreign exchange reserves has also not abated due to on-going payments to the IMF. SBP is, nonetheless, hopeful that change in sentiment post-elections would potentially have a favourable influence on private financial inflows. Besides, declining inflation has increased the relative real return on rupee denominated assets. As for the fiscal outlook, fiscal deficit was estimated to reach 8.8 percent of GDP during FY13 but from the monetary policy perspective, it was the financing pressure of the fiscal position that was the source of fiscal stress. Fiscal borrowings for budgetary support during the current year had reached Rs 1230 billion, including Rs 413 billion from the SBP. This has kept an upward pressure on short-term market interest rates and was also restraining growth in private sector credit.
Policy rate has lost its efficacy as a monetary tool because of insensitivity of government to interest rate. Further, SBP has accepted changes in CPI numbers; therefore, it has to base its decision on these rebased numbers. It has become increasingly clear that policy rate has very little bearing on either inflation and also has very little effect on foreign exchange reserves/balance of payments position. The current poor state of Pakistan's economy is a reflection of adverse consequences of rising debt. Public and external debt have grown over the last five years at an unprecedented pace. Public debt has risen at an average rate of 21.5 percent (between 2008-12) ie from Rs6.1 trillion to Rs 13.6 trillion (between July '08 and March 2013). Within public debt, it is the domestic debt that has risen at a faster pace ie by 24.1 percent per year. It is the domestic debt which is now more worrisome. Therefore, a reduction in policy rate leads to reduced servicing cost in the budget has become a high priority. A 50bps cut is Rs 5 billion cost saving upfront while a 500bps cumulative cut provides Rs50 billion less in debt servicing in the budget. There was space for 150bps reduction in SBP policy rate. But SBP appeared to have hesitated going the whole course because: (a) it feared dollarization; and (b) it did not want to rock the boat for the new government while it has just started negotiation with the International Monetary Fund.
However, it must also be highlighted that it is not uncommon for Central Banks to change their stance when the economy is in a great deal of stress and it has to take unusual steps to give a helping hand to deal with the downside risks to the economy. In our view, if the government could somehow reduce its fiscal deficit as promised and find some alternate sources of financing to reduce its dependence on the budgetary borrowings from the banking system, most of the problems of the economy can be managed and credit to the private sector could increase without high liquidity injections from the SBP. This will not only increase productivity in the economy but would keep the inflation rate within tolerable limits. Increased productivity would enhance exports and reduce pressure on the external sector. The reported ongoing negotiations with IMF, for a new loan to pay for the past loans, are also a good move to guard against the possibility of default. In a situation like this, it is better to give more weight to declining inflation and private sector credit than risks to the balance of payments position and convey a positive signal to the market and the government that the SBP was prepared to go an extra mile if the government was serious in reducing its fiscal deficit and negotiating another programme with the Fund. Most of the other central banks are reducing their discount rates to the minimum possible levels to improve growth rates in their respective economies. The case for such a stance was more compelling in Pakistan because of very high unemployment rate, particularly among the younger generation which may lead to wastage of human resources and social chaos. In our view, the arguments for keeping the policy rate unchanged or reduce it by certain percentage points were almost equally balanced this time. The SBP could even reduce the rate by a higher margin if it was convinced about the deceleration in inflation rate in future. In any case, there was no harm for the SBP in changing the priorities with the unfolding situation which it has done this time. It is better to try to find unorthodox solutions when orthodoxy becomes optimal.