Gradually increasing weakness in fiscal indicators, and the widening of the current account deficit are of serious immediate concerns, requiring corrective policy measures to protect long-term growth prospects of the economy, says the State Bank of Pakistan.
The SBP''''s Third Quarterly Report for the year 2005-06, issued on Saturday, describes the 2007 Federal Budget as expansionary - aiming to give a fiscal stimulus. This will add to aggregate demand and, therefore, to inflationary pressure.
"The impact could be worsened if the government depends heavily on central bank borrowings to finance the deficit. The budget for FY07 envisages a receipt of Rs 35 billion from SBP profits, (a substantial portion of the central bank''''s profitability is from the interest earned on its holding of government securities mainly accruing through the financing of governmental fiscal deficits) which suggests this may be the case, and therefore the burden of containing inflationary pressures will fall disproportionately on monetary policy," cautions SBP.
A relative slowdown in aggregate demand has significantly reduced inflationary pressures. However, as the aggregate demand is still strong, and the economy will benefit from the expansionary fiscal stance, loosening of monetary policy is, therefore, clearly not advisable, says SBP.
Further, due to the current account deficit at 4.3 percent of GDP in FY06 and the availability of external financing, SBP has opted to keep the monetary policy tight to contain excessive volatility in the exchange rate and inflation.
SBP sees strong agri-growth in FY07, due to low base provided by relatively poor performance by major crops in FY06. "This in turn would support an improved performance in key industries such as textiles and sugar, thus supporting large-scale manufacturing."
Going forward, the impact of credit slowdown on inflation may be substantially augmented, by a continuing decline in food inflation following the implementation of the recently announced administrative measures and subsidies by the government, says the report.
The current account deficit at $6.3 billion is expected to be covered by privatisation receipts and strong aid inflows. "This, however, would primarily depend on the realisation of the anticipated moderation in import growth, as forecast in the annual plan and continued strong export growth."
In case the current account deficit proves to be substantially higher, it would be extremely difficult to sustain - without either raising external debt or a recourse to an undesirable drawdown in reserves, or strong measures to contain aggregate demand or a more focused policy of containing external demand, says SBP.
The pressure on the country''''s external accounts increased substantially during FY2006, as the current account deficit swelled to a historic peak of $4.1 billion by end of April 2006, sharply higher than $0.94 billion recorded in corresponding period of FY2005.
Even more significantly, as a percentage of GDP, the annual current account deficit is estimated to rise from an innocuous 1.4 percent in FY2005 to a more troubling 3.2 percent in FY2006, indicating a continued weakening would cause grave risks to hard-won macroeconomic stability achieved in recent years.
As in the previous year, the deterioration in the current account deficit during July-April FY2006 emanated essentially from the trade deficit, wherein gains from a robust 13 percent increase in exports was eclipsed by the exceptionally strong 28.5 percent increase in imports.
Within the current account, the trade deficit of $6.5 billion was accompanied by services account deficit of $3.5 billion, up 36 percent from last year (mainly due to higher transportation and other business charges associated with higher imports).
The income account also recorded a deficit of $2.1 billion. The rise in deficit in the trade, services and income account was partially offset by an increase in the current transfers, which rose from $7.1 billion in July-April 2005 to $8.1 billion in July-April 2006, largely on account of the overseas'''' Pakistanis'''' remittances and increases in official grants.
Pakistan was, however, successful in tapping the international markets to finance its deficit, attracting FDI (including for its privatisation program) and in obtaining financing for developmental projects. All of these, together with rising portfolio investment, are reflected in the country''''s substantial $5 billion financial account surplus during July-April FY2006, as compared to a surplus of only $24 million in the corresponding period of FY05.
As a result, the overall balance witnessed a surplus of $1.4 billion during July-April FY06.
This also helped sustain the relative stability of the exchange rate as the rupee depreciated only 0.88 percent against the US dollar during July-May FY2006 to Rs60.22/$, and sustaining the SBP reserves around $10.6 billion mark by the end of May 2006.