Pakistan's economy has started to show signs of the beginning to an end of a year long period of mounting difficulties and challenges, yet it has not solved all of its problems. The ensuing vulnerabilities and risks posed complex policy questions that occupied the country during most of 2008.
ALONGSIDE IS THE EXECUTIVE SUMMARY OF SBP'S MONETARY POLICY STATEMENT JANUARY-MARCH 2009 The stress on macroeconomic stability was most visible in an unsustainable balance of payments position and the falling value of the rupee. Together with this, escalating CPI inflation, driven both by food and non-food components, and structural problems such as power shortages leading to a gradual decline in real economic activity, aggravated the pressure.
The enormous size and skewed financing mix of the fiscal deficit that tilted heavily towards central bank borrowing, liquidity shortages in the money market, and strains in the overall banking system added to an already worsening situation. The domestic socio-political upheavals and rapidly changing global economic environment also contributed to these multifaceted problems.
These diverse developments entailed complex interactions and led to an increasingly intricate menu of policy trade-offs. In response, and keeping in view the economic outlook for FY09, the SBP tightened the monetary policy further by increasing the policy discount rate by 100 bps in July 2008.
The final judgement categorically stated that the risks to the inflation outlook were far greater than risks to economic growth and reckoned the necessity of well co-ordinated stabilisation measures. Given the emerging liquidity issues, SBP also took a host of measures in October 2008 to address problems related to liquidity management by banks.
In continuation of its resolve to support a return to macroeconomic stability, Interim Monetary Policy Measures were announced on 12th November 2008. The increase in the policy discount rate from 13 to 15 percent was taken after assessing the developments during the first four months of the current fiscal year and seeing no visible turnaround in the highlighted risks and challenges faced by the SBP.
Tight monetary policy, however, was only one ingredient of the macroeconomic stabilisation program; several stabilisation and structural adjustments were required immediately and in the medium term to put the economy back on a stable path. More importantly, the Interim Measures outlined the contours of the macroeconomic stabilisation programme prepared by the SBP and the government.
Since the corner stone of the stabilisation programme was an urgent need to plug the 'financing-gap' of $4.5 billion during FY09, a Stand-By Arrangement (SBA) was signed with the IMF towards the end of November, 2008.
Although it is too early to evaluate the benefits of all the measures that the stabilisation program stipulates, yet by January 2009 there are early signs of improvement in the outlook for some important economic variables such as inflation, foreign exchange reserve, import growth, and government borrowings from the SBP.
Two broad reasons underlie these positive developments. First, some of the important policy measures and adjustments, which are a part of the macroeconomic stabilisation package, have already been working their way through the economy and are likely to contribute towards achieving stability by the end of FY09.
THESE INCLUDE: (i) frequent and timely adjustments in the policy interest rate that resulted in a cumulative increase of 500 bps during 2008 kept the aggregate demand and inflation expectations from spiralling out of control; (ii) rationalisation/elimination of subsidies, especially on petroleum products that had wrecked havoc with the government's budget of FY08.
Out of a budget deficit of Rs 777.2 billion in FY08, Rs 395 billion were spent on subsidies; and (iii) an inevitable yet needed and market driven adjustment in the exchange rate helped in putting a dent in an otherwise unsustainable growth rate of imports.
After a cumulative depreciation of 11.5 percent in FY08 and a further slide of 13.5 percent in FY09 up till 30th January 2009, the import growth has slowed down from 31.2 percent in FY08 to 15.4 percent in H1-FY09.
Second, two phenomena that had hitherto diluted the effects of the tight monetary policy have changed their direction: (i) there has been a noticeable decline in the volume of government borrowings from the SBP for budgetary support.
This has been made possible because preference for subsidy took a back seat, especially after the confidence-invoking and discipline-inducing home grown stabilisation package that also paved the way for successful conclusion of SBA.
For example, during Q1-FY09, the government borrowed Rs 264.4 billion from the SBP, while this amount reduced to Rs 44.3 billion during Q2-FY09; (ii) After touching a record high of $147.3/bbl on 11th July 2008, oil prices have slumped to around $40/bbl as on 27th January 2009; a fall beyond national and international expectations and projections.
This drastic fall in international prices will provide a much needed respite for the trade account and coupled with tight monetary policy and prudent exchange rate management will strengthen the balance of payments position. CPI inflation is also likely to benefit from this development.
Despite these preliminary positive indications it would be imprudent to lower the guard at this stage. A number of measures suggested in the stabilisation package, especially those related with structural issues, still need to be implemented to put the economy back on a sustainable path of growth and development.
Even the macroeconomic indicators that have recovered and the ones likely to post improvement in the next six months justify only restrained optimism on close inspection. Furthermore, the full impact of demand and liquidity management measures taken by the SBP during 2008 have yet to materialise.
The excessive drain of rupee liquidity from the system in October 2008, which was precipitated by falling net foreign assets, strong credit demand, and other seasonal factors, was largely addressed by a staggered lowering of Cash Reserve Requirement (CRR) and exemption of time liabilities from the Statutory Liquidity Requirement (SLR).
As a consequence, however, overnight repo interest rate fell in the following weeks and continued to remain at a relatively lower level even after the increase in the policy discount rate on 12th November 2008 by 200 bps. The low levels of weekly average overnight repo rate of around 10.3 percent (for the week ending 23rd January 2009) essentially entail softening of the monetary policy stance.
This was done consciously by the SBP to keep money market sufficiently liquid while remaining vigilant in draining excessive liquidity build-ups. Two consideration prompted the SBP to remain cautious in mopping up the liquidity.
(i) there were concerns about some lingering effects of liquidity problems in some segments of the market; (ii) it allowed the banks to increase their participation in the T-bill auctions and thus helped in lowering the reliance of the government on borrowings from the SBP. In the six auctions held since the Interim Monetary Policy Measures, November 2008, Rs 482.1 billion was realised to the government against the maturities of Rs 321 billion, which helped the government to meet its end-December targets under the SBA.
A prudent approach to liquidity management is necessary in the current circumstances to ensure meeting quantitative targets in the SBA. Floor on SBP Net Foreign Assets (NFA) and ceilings on SBP Net Domestic Assets (NDA) and government borrowing from SBP will ensure that softening market interest rates remain consistent with achieving macroeconomic stability.
In fact, reducing government borrowing from SBP will also help entrench expectations of a sustained decline in inflation. Moreover, increased participation of banks in auctions indicates their reluctance to extend credit to the private sector and hint towards the slowdown in economic activity. Hence, softening of market interest rates is a welcome development.
However, given a high inflation environment which induces people to hold more cash, accommodation of liquidity shocks does not bode well for pinning long-term inflation expectations. One of the reasons for increasing the policy rate in November was to strike a balance between these considerations.
Another consequence of adequate liquidity is that the Karachi InterBank Offer Rate (KIBOR) has remained flat after the policy rate increase and even declined in January 2009.
As on 30th January 2009, both the 3-month and the 6-month KIBOR of 14.5 and 15.2 percent are lower than their respective levels of 15.4 and 15.7 percent as on 12th November 2008; just before the increase in the policy discount rate. This is partially because the market had already factored-in the imminent interest rate hike.
The result is that the Weighted Average Lending Rate (WALR) on incremental loans has eased somewhat (14.3 percent in December 2008) leading to a fall in the real interest rates. As has been argued by the SBP in previous Monetary Policy Statements, it is the real interest rate that needs to increase in order to ring the domestic savings in line with the investment requirements of the economy. Failing to do so has resulted in a continued and unnecessarily increasing reliance on foreign savings.
This provided little incentive to align domestic aggregate demand with the productive capacity of the economy. Eventually, shocks to foreign resources in 2008 such as the global financial turmoil and domestic turbulence exposed the domestic vulnerabilities and resulted in a fall in reserves, considerable depreciation of rupee, and a persistent rise in inflation.
A careful analysis of monetary aggregates also expose the consequences of a widening saving-investment (or aggregate demand-aggregate supply) gap. The depreciation of rupee was mainly reflecting a sharp fall in the NFA component of money supply (M2). Similarly, stubbornness of inflation was partially because of a significant expansion in the NDA, driven largely by government borrowings from the SBP.
Recent data reveals that the rate of increase of government borrowing from the SBP (and thus the NDA) has slowed down and the foreign exchange reserves (and thus the NFA) have improved. This offers a glimpse of a certain degree of stability to come by the end of FY09.
However, in absolute terms, an expansion in NDA (Rs 360 billion) and contraction in NFA (Rs 303 billion) during 1st July-17th January FY09) still represents a disproportionate increase in rupee liquidity relative to the availability of foreign exchange.
The expected rate of growth of M2 for FY09 consistent with the projected fiscal deficit of 4.6 percent of GDP and external account deficit of 7.0 percent of GDP turns out to be around 9.0 percent. This is the equilibrium growth of money that is consistent with the given forecasts for the fiscal and external sectors and the projected real GDP growth rate of 3.7 percent.
Despite the anticipated improvements in the twin deficits and slowdown in real GDP growth, a projected average inflation rate of 20 percent for FY09 is still quite high and explains the reasons for the current high level of policy discount rate. It also highlights the importance that SBP has placed on controlling inflation.
In order to take advantage of the improvement in the composition of monetary aggregates, it is important to encourage factors for the emerging signs of stability, that is, government should continue to keep borrowings from the SBP under control and ensure the build-up of reserves.
This can be achieved by bringing down the level of fiscal deficit and external current account deficit to sustainable levels; important features of the stabilisation program. Elimination of subsidies, partial transfer of oil payments to the foreign exchange market, and fall in the international oil prices should help on these fronts.
The risks involved in this context are twofold. First, the target for tax revenues, in the wake of a slowing economy has begun to look a bit ambitious. During the first six month, the FBR tax revenue collection amounted to Rs 543.7 billion against a (revised) target of Rs 581 billion for H1-FY09 and Rs 1360 billion for FY09.
To avoid a slippage in the fiscal deficit target the government will need to keep its expenditures in check. Second, expected decline in import growth to around negative 5.0 percent due to a fall in international prices and depreciation of rupee may be neutralised by a slowdown in export revenues-expected to decelerate to around 2.0 percent-because of the deepening global recession.
Lower external demand for exports coupled with energy shortages, law and order situation, and pending circular debt issue are expected to drag the growth of the domestic economy in FY09, particularly of the industrial and services sectors. The dismal performance of Large Scale Manufacturing (LSM) during the first five months of current fiscal year and falling private sector credit are an indication of weakening real economic activity.
The expected better performance of the agriculture sector may support the growth prospect to some extent. Nonetheless, the overall GDP growth is still projected to remain around 3.7 percent in FY09, which is lower than last year's growth rate of 5.8 percent but is still respectable.
Finally, it is important to stem the current level of inflation from becoming chronic since there is a risk that the current experience of higher prices may get entrenched in expectations of economic agents.
Expected decline in the fiscal and external current account deficit and government borrowings from the SBP point to easing of aggregate demand pressures and would help on this front. Similarly, falling international commodity prices are an indication of slackening supply shocks, which is also helpful for the inflation outlook.
However, record high international commodity prices during 2008, especially oil, not only had a level effect on the imported component of domestic CPI but gradually spilled over to other categories. This affected both the actual and expected inflation and explains its persistence.
Though the increase in CPI inflation has somewhat eased, the high level of inflation and rigidity of core inflation remain a source of concern. The YoY CPI inflation is projected to come down to 12 percent in June 2009, but the average CPI inflation for FY09 is likely to remain in the vicinity of 20 percent.
Based on these considerations, it is clear that by the end of FY09 there will be some reduction in both the fiscal and external current account deficits relative to FY08. However, not only is the expected magnitude of these deficits quite high but also there are risks of slippages. This signifies that the demand pressures have not completely dissipated and are likely to persist in H2-FY09, despite a slowdown in economic activity.
Similarly, the high expected average CPI inflation of 20 percent for FY09 (significantly higher than the FY09 target of 11 percent) and its persistence, reflected by core inflation measures, clearly reflect the risk on this front. To mitigate the implications of these risks it is important to continue with the current monetary policy stance. Therefore, the SBP has decided to keep the policy discount rate unchanged at 15 percent.
In order to further strengthen and segregate the responsibilities of debt and monetary management following steps have been taken: (i) prior announcement of the auction calendar for Treasury Bills (T-bills) and Pakistan Investment Bonds (PIBs) and a volume based approach to determine the auction result.
These are positive steps in the development of a liquid government debt market; (ii) Ministry of Finance will henceforth be responsible for deciding the cut off yields of the primary auctions of T-bills and PIBs on the above premise.
State Bank of Pakistan will continue to manage the operational aspect of the auctions and there will be no change in the process as far as the market is concerned; (iii) next step in the segregation of debt and monetary management would be to work toward introducing limits on the direct government borrowings from the SBP and along with a plan to eliminate the same in a phased manner over next several years.
To facilitate the banks in providing finance to the exporters and support the industry SBP has decided to further enhance banks' limits both under EFS and LTFF Schemes by Rs 35 billion. As a result total limits under EFS will increase by Rs 25 billion from Rs 181.3 billion to Rs 206.3 billion.
Resultantly, cushion of Rs 46.4 billion will be available with the banks over and above their current utilisation of facility for meeting the requirements of the industry. Further in order to support long term investment in new plant and machinery, the limits under LTFF have also been enhanced by Rs 10 billion from Rs 9.5 billion to Rs 19.5 billion.
In addition it has been decided that the SBP will issue Monetary Policy Statement (MPS) on quarterly basis. This is a significant step in current fast evolving economic environment and will enhance the effectiveness of monetary policy transmission. The MPS for the next quarter will be issued by the end of April 2009.