Even if consumer prices, from November 2008 onwards, remain constant (ie monthly inflation change is zero) at October 2008 level, average inflation will be close to 20 percent, says the State Bank of Pakistan. Giving the outlook for the current financial year, the central bank said it expects FY09 growth to be onward 4 percent.
SBP says that the aggregate demand pressures have not yet subsided; productive capacity as reflected by data on large-scale manufacturing is declining due to the law and order situation; and structural weaknesses such as power shortages etc reflecting a widening output gap (the difference between aggregate demand and productive capacity.
If the domestic demand grows at 5.0 percent (which is less than the last five-year average of 6.6 percent) and the real GDP grows by 4.0 percent in FY09, the difference between domestic demand and supply is expected to widen further.
Therefore, the output gap is likely to remain more or less unchanged, if not increased. As a consequence, the anticipated effect on inflation through this channel may not be realised. Thus, the need to curb aggregate demand has heightened, and the role of fiscal as well as monetary policy in addressing this predicament has become all the more important.
It is important, therefore, says SBP, that at the same time all necessary steps should be taken to enhance the productive capacity of the economy. One key input in this regard is the substantial increase in investments for this purpose.
In the wake of dwindling availability of foreign savings, generating and channelling domestic savings - public as well as private - can play a significant role in meeting the investment requirements. Thus, curtailing this output gap would, in fact, help in reducing the saving investment gap in the economy, thereby reducing the reliance on external resources. To encourage savings, the real returns will have to be increased significantly.
The importance of coping with all economic challenges and mitigating the risks appear all the more important, given the fact that even if the current encouraging trends in international prices and domestic demand pressures continue. The end of the year situation, though, shows improvement over the current and the FY08 levels, the outcome appears still away from the desirable and sustainable levels.
Specifically, says SBP, inflation is expected to decelerate during H2-FY09, as the global commodity prices are declining and the monetary tightening measures adopted in May and July 2008 are anticipated to have a lagged impact on inflation. Thus, the YoY headline inflation is projected to come down from 25.0 percent in October 2008 to around 14 percent by June 2009, while on average basis, inflation will be closed to 21 percent for FY09; well above the 11 percent target for the year.
Although the deceleration in inflationary pressures are encouraging, the need to bring it down to single-digit level remains a top priority as the level of inflation, consistent with sustainable growth, is estimated at 4-6 percent for Pakistan''''s economy. Achieving this objective in the medium-term requires aligning aggregate demand in the economy in line with the aggregate supply.
Further, imports are anticipated to slow down considerably, owing to the falling international commodity prices and domestic demand moderation. Assuming the current level of international oil prices continue for the remainder of the current fiscal year and a slowdown in domestic demand is realised due to a depreciated rupee, import growth for FY09 is expected to be around 2.0 percent, and may even turn negative.
On the other hand, the growth slowdown/recession in Pakistan''''s major trading partner countries, particularly US, EU, and Japan, is likely to have an adverse effect on exports. It is projected that exports earnings may register a growth of around 10 percent during FY09. Based on these projected imports and exports, and assuming a continuation of existing trend in workers'''' remittances, the external current account deficit is estimated to lie between 6.2 and 6.8 percent of GDP.
Although this deficit is showing improvement over last year, it is still unsustainable. Given the uncertainty regarding the foreign inflows and the need to build up the country''''s foreign exchange reserves to end-June 2008 levels, the ''''financing gap'''' is expected to be around $4.5 billion.
FISCAL DEFICIT: Given the urgency and commitment of government to eliminate reliance on borrowing from the SBP to finance the fiscal deficit and the lower availability of external financing, the fiscal deficit will have to be cut considerably, even lower than the projected 4.7 percent of GDP target for FY09. This translates into a very well defined prioritisation of expenditures and strong revenue mobilisation efforts.
The impact on the monetary sector of these expected developments in the external and fiscal sector will be reflected in a monetary growth of around 12 to 13 percent. The projected improvement in the external current account deficit and government efforts in further reducing its fiscal deficit than initially planned, will not only allow monetary growth to remain within this desirable limit, but also help in improving the composition of M2 - ie by increasing the share of Net Foreign Assets (NFA) and containing the growth in Net Domestic Assets (NDA). Moreover, the lower government financing requirement from domestic sources will allow higher credit to private sector.
SBP hopes that with a slowdown in aggregate demand, as expected due to declining external current account and the fiscal deficit, the overall growth in the economy is expected to trim down to 4 percent during FY09. Worsened law and order situation and structural weaknesses such as power shortages etc are mainly responsible for this slowing economic growth.
An economic growth of 4 percent is consistent with the expected developments in the fiscal, external, and monetary sectors and inflation outlook. While removing these bottlenecks is imperative in achieving sustainable economic growth, in the interim period, focus of macroeconomic policies should remain on curtailing domestic demand.
Though this growth is lower than the target of 5.5 percent and actual estimated growth of 5.8 percent in FY08, decision whether this growth should be maintained or even sacrificed depends on the evaluation of the trade-off between inflation and growth.
In conclusion, says the central bank, it must be remembered that tight monetary policy is only one ingredient of the macroeconomic stabilisation program. Several stabilisation and structural adjustments in the fiscal, external, and financial sector are required immediately and, in the medium term, to put the economy back on a stable path.
The crux of this program revolves around building the country''''s foreign exchange reserves, supported with appropriate exchange rate policy, and bringing the fiscal deficit to sustainable levels by rationalising expenditures and strengthening tax revenue generation. It is anticipated that fiscal tightening of the desired level will ensure that monetary tightening stance is not undermined.
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Activity in Interbank Market
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10-Nov Aug-Nov
Jul-08 Aug-08 Sep-08 Oct-08 08 2008
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OMOs
Injection (billion Rs) - 78.2 176.4 187.3 39.4 481.3
Mop up (billion Rs) 359.9 41.2 27.0 36.0 105.3 209.5
Frequency (Nos) 14 7 11 12 5 35
Discounting
Amount (billion Rs) 23.5 42.9 247.4 37.2 59.6 387.0
No of visits 6 5 13 10 8 36
Market interest rates (end of month)
0/N Repo rate (WA) 9.1 11.3 12.6 12.3 10.5
Call rate 10.3 13.7 19.2 16.3 14.9
Kibor (6-month) 13.5 13.8 14.5 15.1 15.7
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