No change, said the SBP''s verdict on Saturday - as per market expectations and IMF''s directions. To understand SBP''s reasoning behind the decision, one has to look at the three interrelated price variables that the monetary policy uses as tools for macroeconomic stability - inflation, interest rates and exchange rate.
Inflation remained in a single digit throughout the year, although it was volatile owing to cyclical movement in perishable food items and changes in administrative prices. The SBP seems comfortable on the stability of core inflation around 8 percent and its outlook is positive - CPI at 8 percent in FY15.
In isolation, to keep real interest rates close to zero there was a case for a rate cut. However, the government''s target of 8 percent inflation for the full year will be missed. Usually, government targets are unrealistic and have not been taken seriously in formulating policy decisions lately. This coupled with the Fund''s assertion of bringing inflation down to 6-7 percent gave enough room for hawks at the SBP to sideline proponents of monetary easing.
The second important variable is exchange rate. Real Effective Exchange Rate has appreciated by 8 percent in 3QFY14. This is making goods produced at home expensive to those in the trading partners and makes our exports less competitive and also threatens local industries, catering to domestic market, with imports. This is a serious concern and has to be dealt with care for stabilisation of improved macroeconomic indictors.
Economic managers had to choose between the two - lowering interest rates or depreciating nominal exchange rate. Both have their own merits and demerits, but it''s not viable to ease all the monetary instruments at the time when the country does not have the fiscal space. Finance Minister Ishaq Dar''s love to keep rupee-dollar parity below one hundred is known to all and probably incorporating that the fund has used strong words for keeping interest rates high for further building of foreign exchange reserves and combating inflationary pressures.
This strategy is a double whammy for industrial sector as manufacturers are losing international competitiveness due to expensive currency as well as high cost of borrowing is hampering profitability too. Clearly, this strategy cannot run for long and sooner or later both exchange rate and interest rates have to be adjusted to attain a new equilibrium. Otherwise efficacy of central bank policy rate would diminish - reminiscent of 2002-4.
A few would have argued that exchange rate appreciation is due to a sudden surge in foreign reserves - SBP reserves have more than doubled from its low of $3 billion in November to cross $8 billion in May. The REER appreciation is around 5 percent from the time when reserves were at a similar level in March 2013. There is no sane economic theory that justifies disequilibrium in exchange rate.
Anyhow, interest rates and exchange rates are just two variables to indicate the health of macro economy. Some other indicators are promising. "The flow of net credit to private sector was almost two and a half times more during the first nine months of current fiscal year compared to the corresponding period of last year. Similarly, the monthly average gross credit disbursements, arguably a better gauge of the nexus between credit and production, during the same period are about Rs150 billion higher this year," noticed MPS. This, according to the central bank, has resulted in better performance of various sectors, especially manufacturing concerns. Provisional estimates of real GDP show a growth of 4.1 percent in FY14 and this is led by industrial output which is up by 5.8 percent.
"On the external side, current account deficit which is in the vicinity of one percent of GDP is a good omen. In fact, the SBP was able to meet the IMF''s adjusted Net International Reserve (NIR) target for end-March 2014 by a wide margin," pointed out the MPS.
Then the SBP naively pointed out that despite a shortfall in budgeted tax revenues, the government has been able to curtail the fiscal deficit to 3.1 percent. The central bank didn''t or couldn''t pick the ingenious accounting treatment by Ministry of Finance in the third quarter. Dr Hafiz Pasha pointed out that Rs171 billion accounted in ''statistical discrepancies'' is extraordinarily high and government probably has hidden a grant of Rs 150 billion from Saudi Arabia in it. Had that been incorporated, fiscal deficit without grant would have been at 3.7 percent of GDP.
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