100bps hike in policy rate

In its meeting held on 16th July, 2019, the Monetary Policy Committee (MPC) of the State Bank again decided to raise the policy rate by another 100 basis points (bps) to 13.25 percent per annum for the next two months. According to the Monetary Policy Statement (MPS) issued after the meeting, the decision takes into account upside inflationary pressures from exchange rate depreciation since the last MPC meeting, the likely increase in inflation from the one-off impact of recent adjustments in utility prices and taxation measures taken in the FY20 budget. Other developments since the last MPC meeting include the federal government's commitment to credibly improve fiscal sustainability in its budget for FY20, decision of the government to cease borrowings from the SBP, strengthening of the outlook for external financing with the disbursement of first tranche of the IMF Extended Fund Facility, activation of the Saudi oil facility, and other commitments of support from multilateral and bilateral partners. As for other developments, the SBP expects the real GDP growth of around 3.5 percent in FY20. It is worth noting that the SBP has projected a growth rate for the current year which is higher than the budget estimates because the State Bank expects the economy to turn around during the course of the year on the back of improved market sentiments in the context of IMF-supported programme, a rebound in the agriculture sector and a gradual impact of government incentives for export-oriented industries.
On the external front, the current account (C/A) deficit has fallen by 29.3 percent to dollar 12.7 billion in July-May, FY19 compared to dollar 17.9 billion in the same period of last year due primarily to import compression and healthy growth in home remittances. SBP's foreign exchange reserves have also risen to about dollar 8 billion as on 12th July, 2019 and are expected to rise further in FY20 on account of financial inflows from international creditors, Saudi oil facility and improvement in C/A deficit. Both the overall fiscal and primary deficits deteriorated during FY19 due to a substantial fall in revenue collection, higher than budgeted interest payments and security-related expenditures. Inflation rose considerably to 7.5 percent in FY19 due to increased government borrowings from the SBP, lagged impact of exchange rate depreciation, hike in domestic fuel prices and rising food prices. The MPC expects inflation to average between 11-12 percent in FY20. This rate of inflation is somewhat lower than some other estimates that project the average inflation of around 13 percent in 2019-20. The MPC has also added that "real interest rates implied by these inflation projections and today's policy rate decision are at appropriate levels considering the cyclical weakening of aggregate demand."
Although the decision of the MPC to raise the policy rate by 100 bps would appear to be harsh or somewhat excessive, the MPC makes it quite clear that it was necessary under the circumstances. Inflation is likely to be in double digits during FY20 and a hike in the policy rate was the best option to contain it within reasonable limits. C/A deficit, although lower than last year's, continues to constitute a serious threat to economy. Our policymakers, nonetheless, seem pleased that they have been able to procure enough financing to fill the gap in the external sector without realising that these are borrowings which are to be repaid with interest and no creditor would be generous enough to offer the country a free lunch. Obviously, if the MPC had not raised the policy rate, it would have become more lucrative to hold foreign currencies and the pressure on the balance of payments would have intensified further. The sharp depreciation of rupee in the foreign exchange market has been instrumental in curtailing imports but has not led to an increase in exports so far due to capacity constraints and the time it takes to find buyers in the international market. A marked slowdown in GDP growth rate is another reason for high inflation due to supply constraints. Fiscal policy is also not supportive. Overall fiscal deficit as a percentage of GDP is likely to exceed 7 percent in FY20. Monetary policy has also to bear the burden of an expansionary fiscal policy to moderate the rate of inflation.
While the recent trends in the relevant major macroeconomic indicators have called for a continued stringent monetary policy, the State Bank this time has offered another reason for a hike in the policy rate which appears to be unique and reflects poorly on the economic management of the previous government. The MPS states very clearly "that the adjustment related to interest rates and the exchange rate from previously accumulated imbalances has taken place" and the bulk of the needed adjustment in the real effective exchange rate to address the past overhang of overvaluation has been completed with the recent depreciation of the exchange rate. Simply put, the MPC has blamed the previous government for the delay in correcting the overvaluation of the rupee and upward adjustment in the policy rate to counter inflationary pressures in the economy while the present government is not only obliged to make amends for the past mismanagement but has to stabilise and revive the economy with unpopular policy decisions. Another important observation made in the MPS is that backlog of omissions by the previous government has now been cleared and going forward, only overall domestic demand and the current inflationary pressures will determine the monetary policy. In other words, policy rate hikes witnessed during the tenure of PTI government have been necessitated primarily by inordinate delay in implementing the necessary adjustments for political expediency and future monetary policy will only be guided by the current situation in the relevant variables.
The MPC, nonetheless, seems to be somewhat overoptimistic about the fiscal outcome during FY20. It has observed that the budget for FY20 envisages a sizeable reduction in primary deficit on the strength of an ambitious target for tax collections and tight control over expenditures and the resultant fiscal consolidation would support SBP's stabilisation policies. The past experience and the present stiff opposition to the budgetary measures across the country suggests that the target for tax collections fixed for FY20 is very difficult to achieve and, contrary to SBP's expectations, the fiscal policy may not be able to support its stabilisation policies in the near future. On the flip side, some of the analysts and commentators have started questioning the role of successive interest rate hikes in containing or minimizing price pressures in the economy. Although a sharp depreciation of rupee, increases in utility prices, recent budgetary measures, etc., may be the reasons for an uptick in inflation, it will be better for the SBP to explain this puzzle for the satisfaction of those who may doubt the efficacy of the monetary policy in containing inflation.