The rate cut has brought a sigh of relief for an otherwise disgruntled business community. The decision is better than the expectations as most of the analysts and economists were anticipating 50bps cut which was supposedly in line with IMF's directive. BR Research was also in favour of a 50bps cut. Inflation is down and is expected to remain low in the second half as well - SBP's projection of full year inflation was revised down to 4.5- 5.5 percent (annual target: 8%) while BR Research's estimates are even less than that.
The current account is expected to be in surplus in 2HF15 and F16. The monetary aggregate expansion is half this year so far of what it was in the corresponding period last year. NFA to NDA ratio has improved. The private sector credit is anemic and growth is finding hard to gain momentum.
All these factors call for an aggressive cut in the policy to give some relief to the private sector credit. But haste is no good, knowing our economic vulnerabilities to balance of payment crises and persistent structural weaknesses in the fiscal house. Consumers are already enjoying a boost while the rupee is kept artificially appreciated. A big cut in interest rates in addition to this will make the objectives of sustainable foreign reserves building and continuity of lower inflation era more challenging.
"...Non realisation of planned privatisation proceeds and lack of private inflows could pose risks in achieving a sustainable BoP position," lamented SBP. There are no signs of pick in abysmally low foreign investment. The exports to GDP ratio continues to decline in FY15 despite of GSP plus status. One of the reasons for this fall is real appreciation of rupee by 3.4 percent in July-November 14. It would have been appropriate to use exchange rate tool along with a cut in interest rate to pick up the industrial growth.
The argument is supported by the fact that credit in non-exporting industries is picking up as lower commodity prices have increased disposable incomes and lower inflationary expectations have improved sentiments. Cement and chemicals sectors have shown a better financial performance and there is some credit uptick in these sectors. On the flip side, margins for the textile sector have been squeezed.
The overall private credit declined by 31 percent to Rs 225 billion in 1HFY15. This is partially responsible for lowering M2 growth to 2.6 percent; year to date from five percent in the same period last year. The rest is due to the retirement of fiscal debt of central bank - government retired Rs 448 billion from the central bank in year to date as against the borrowing of Rs 663 billion in the corresponding period last year. The gap has been filled by scheduled banks (borrowed Rs 703bn against retirement of Rs 95 billion) and by external inflows of Sukkuk and CSF flows.
This is a quick fix but not sustainable as tax revenues are not increasing while expenditures are hard to curtail. FBR needs an unrealistic 42 percent growth in 2HFY15 to meet its full-year target. The higher interest payments are making it hard to keep current expenditure within permissible limits. The good omen is a decline in lending to PSEs which is not only offsetting the impact of higher interest payments but also providing room for development expenditure. But not letting the money get to companies like PSO can trigger crises like the recent fuel shortage.
Yet meeting the fiscal deficit target of 4.9 percent seems impossible and questions the sustainability of low inflationary era. The current account deficit in 1HFY15 at $2.4 is higher than what it was in the same period last year although, the second quarter is better owing to a steep fall in oil prices; the only silver lining that is anchoring better expectations. The signs are already there; petroleum group imports are down by 10 percent in 1HFY15, even as overall imports grew by 13 percent. This shows that a fall in oil prices is not enough to improve the trade deficit and the steady appreciation in real effective exchange rate is eroding the potential of improving trade balance.
But the hope is that the oil price decline may substantially over-compensate other factors. However, the fall in prices can induce demand as well. For the last decade, the demand of petroleum imports virtually remained same at around 20 million tons, but the gap in energy supply and demand remained high. Lower prices can substantially increase the volumes of imports - idle capacity of power sector can be utilised as furnace oil prices are down by half, LNG import may add $1-1.5 billion of imports per annum, and the petrol consumption increase is already visible.
Hence, it is better to see the elasticity of energy demand before too much easing in policy rate. Then lower inflation and lower oil prices and expensive currency are increasing disposable income of households and can increase aggregate demand. Do we have room in supply to meet it? That is why two of the independent directors of SBP board were of the view that no change should be made to the discount rate or that the cut should be limited to 50 basis points. But others including the Finance Secretary were reportedly dovish and some even proposed a cut of 150 basis points. At the end consensus was reached at the level in line with the suggestion of the internal committee of the central bank.
One of the reasons for an aggressive cut is to stop the banks from seeking high rents. The liquidity mostly remained short in the 1HFY15 and especially in the second quarter. That is due to high fiscal financing on the commercial banks as to meet the IMF's target of net zero borrowing from the central bank. But in essence, the central bank was providing liquidity to banks through reverse repo and banks in turn conveniently deploying that in PIBs at higher rates. The purpose of stopping inflationary borrowing from central bank is defeated as long as SBP consistently provides liquidity to commercial banks for fiscal financing. It has to stop, now with rates low, government papers might not be as lucrative and the hope is banks may start doing some financial intermediation.
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