Policy rate uptick

The Monetary Policy Committee (MPC) of the State Bank of Pakistan has decided once again to raise, albeit slightly, the policy rate by a margin of 0.25 percent to 10.25 percent effective 1st February, 2019 and the decision seems to have been based on some cogent grounds. According to the Monetary Policy Statement (MPS) released after detailed deliberations, although the stabilisation measures implemented during the last one year are taking hold, challenges to the economy continue to persist. Core inflation was persistently high, fiscal deficit was elevated and the C/A deficit, despite some narrowing, remained high. Average CPI inflation was recorded at 6.0 percent during July-December, 2018 or considerably higher than 3.8 percent registered in the same period of last year. Core inflation, as measured by non-food non-energy components of the CPI basket, had reached 8.4 percent in December, 2018. After taking into account various factors, the projected range of inflation by the SBP was between 6.5-7.5 percent for FY19. Real economic activity had witnessed a marked slowdown during the first half of the year. LSM, which has strong backward and forward linkages, saw a net contraction of 0.9 percent during July-November, 2018. All major Kharif crops recorded a decline in production and the initial assessment of wheat crop was also not encouraging. This was likely to reduce the real GDP growth for FY19 to around 4 percent, well below the annual target of 6.2 percent and 5.8 percent growth realized in FY18.
Credit to the private sector expanded by Rs 570.4 billion which was almost double the amount of expansion during the same period last year. Net budgetary finance from SBP reached Rs 3770.5 billion during 1st July - 18th January, FY19 which was 4.3 times the amount borrowed during the same period of last year. A major chunk of this borrowing was used to retire government debt from commercial banks (a net retirement of Rs 3035.8 billion). Fiscal deficit during the first half of FY19 was likely to be higher than last year's despite a sharp cut in PSDP releases and rationalisation of tariffs and duties.
On the external front, the CAD (current account deficit) recorded a YoY reduction of 4.4 percent during the first half of the year due to deceleration in the import of goods and services, a marginal increase in exports and a healthy growth in remittances. The financing of CAD, nonetheless, remained challenging as FDI and official inflows were insufficient to completely finance the deficit. A significant part of CAD, therefore, had to be managed by reducing the SBP's net liquid foreign exchange reserves to only dollar 7.2 billion by end-December, 2018.
In view of the above macro-economic situation, it is hardly surprising that the MPC of the SBP has opted to raise the policy rate by another 25 basis points to 10.25 percent. In the circumstances narrated above, it could either keep the policy rate unchanged or increase it marginally to expedite the stabilisation process of the economy. In fact, since the last MPS effective 3rd December, 2018, the underlying inflationary pressures have heightened, fiscal deficit has elevated despite a 'mini-budget' presented by the PTI government and a drastic cut in development expenditures, domestic and external debt was mounting, a marked shift in the pattern of government borrowing from scheduled banks to the central bank had taken place and the CAD deficit, despite some improvement, still continues to be high and unsustainable. All these indicators show that imbalances in the economy continue to accentuate and the SBP had no alternative but to tighten the monetary policy to carry the load of a flawed fiscal policy and unsustainable balance of payments position. If the SBP had continued to persist with an easy monetary policy, the price pressures would have exacerbated further, the depreciation of Pak rupee would have been more pronounced and the quality of life of ordinary people would have deteriorated further. We feel that the country's fiscal policy is required to have played a more supportive role to the monetary policy tightening to generate conditions for price stability and sustainable growth. Unfortunately, however, the fiscal authorities of the country are not prepared to play their due role and continue to offer concessions and exemptions to some vested interests and entrenched lobbies, ignoring the fact that increasing fiscal deficits are hard to control later on and could contribute to a number of problems in the economy. More worrying is the fact that fiscal policy planners continue to shift government borrowings from scheduled banks to the SBP. Such a policy may release financial resources for the private sector, which is evident in the sharp increase in the private sector credit during the first half of FY19, but is highly inflationary and could be a sticking point while negotiating a programme with the IMF.
Tightening of monetary policy was also necessary for supporting the external sector accounts of the country. By raising the rate of return on rupee holdings and government securities, the authorities could induce the foreign currency holders and expatriate community to convert their savings into domestic currency and invest it into rupee-denominated assets. A higher real rate of return (adjusted for inflation) made possible by the increase in policy rate could also help contain demand and improve dismal saving rate of the economy. The increase in policy rate could have been avoided to a certain extent if availabilities in the economy as measured by the level of GDP and imports, would have been sufficient to take care of the additional doses of liquidity. Since the GDP growth rate is projected to grow only by 4.0 percent or so due to a slowdown in the industrial and agricultural sectors accompanied by stagnation in the services sector and imports have to be squeezed due to foreign exchange constraint, the monetary authority of the country had to be more active to ensure price stability through a rise in the policy rate. Undoubtedly, debt servicing of the country would increase and the entrepreneurs would complain about the rise in the cost of production due to increase in the policy rate. However, such concerns are insignificant in view of the gains likely to be had by sending a strong message across that the SBP is alert to the situation.