As strongly expected, the State Bank of Pakistan on Tuesday announced that its policy rate would remain unchanged at 13 percent amid fear of fiscal slippages and concerned that inflation may not have peaked and uncertainty regarding the outcome of ongoing fiscal consolidation, resolution of electricity problem, and timing of official foreign inflows.
This decision was taken at a meeting of the Central Board of Directors of the State Bank held here under the chairmanship of SBP Governor Syed Salim Raza. The SBP Central Board also decided to constitute a nine-member Monetary Policy Committee (MPC) which includes Governor Salim Raza, Yaseen Anwar, SBP Deputy Governor, and three SBP executives. The SBP said that inflation and other key issues called for prudence at this point and likely to determine SBP's policy trajectory in the coming months.
"Macroeconomic considerations and outlook that influence monetary policy decision depict a mixed picture. While inflation (YoY) and balance of payment position has improved, fiscal and real sector performance remains tenuous," the SBP said. Domestic financial markets functioned adequately but lending to the private sector remained subdued.
From a forward looking perspective, expected improvement in the external current account and emerging global economic recovery augur well for Pakistan's economy, the central bank said and added that limited progress on electricity shortages and stressed fiscal position diluted some of the optimism.
Similarly, inflation outlook was not completely benign yet, as depicted by recent monthly trends. Under these circumstances, assessment of balance of risks continued to be somewhat uncertain. Both CPI and core inflation had declined further in August 2009, with former at 10.7 percent and Non food Non energy (NFNE) measures of the latter at 12.6 percent on year-on-year basis.
However, the pace of decline in inflation was less than expected. The monthly increase of over 1.5 percent in CPI inflation in the first two months of FY10 is still quite high and of concern. This monthly increase coupled with administrative issues in the supply chain of food items and projected increases in electricity prices to eliminate subsidies could have a bearing on the behaviour of domestic inflation in the coming months.
Increase in international oil prices remains an underlying risk to inflation as well, the SBP said. It said that likely presence of Ramazan seasonality in the CPI index, especially the food basket, and disproportionate contribution of only a few items called for caution in interpreting recent monthly inflation indicators.
Similarly, the effect of cost push shocks like electricity and oil on inflation may be neutralised by below capacity economic activity and slow aggregate demand. "Moreover, expectations of inflation are likely to remain in check while the stabilisation program remains on track. While it is likely that inflation will continue its secular decline, as observed in our last communication, there are risks to watch as we go forward". Tapering aggregate demand pressures in the economy can be clearly seen in persistent and widespread decline in imports.
Supported by continued strong inflow of workers' remittances, this fall in import growth has resulted in a modest surplus of $82 million in the external current account for August 2009. Even the cumulative July-August, FY10 external current account deficit of $527 million is much lower than earlier projections. Similarly, on the back of favourable revisions regarding outlook of Pakistan's economy by international rating agencies, portfolio inflows are now positive with 55 million dollars in the first two months of FY10.
This, together with inflows from the IMF, both for budgetary support (745 million dollars) and allocation of increased Special Drawing Rights (around 1200 million dollars), and adequate, though lower, foreign direct investments substantially improved the external financial account.
Resultantly, the SBP's foreign exchange reserves have increased to 10.9 billion dollars as on 28th September, 2009 - an improvement of 1.8 billion dollars since the beginning of FY10 - and is reflected in Rs 123.6 billion increase in the Net Foreign Assets (NFA) during 1st July - 19th September, 2009. This has helped liquidity conditions in the economy and translated into bringing stability to the foreign exchange market.
This improvement in balance of payments is despite a significant shortfall in non-IMF official financial inflows. Non-realisation or shortfall in these official inflows could pose a potential problem for fiscal management, which faces significant pressure on both the expenditure and the revenue side of the budget and has already posted a fiscal deficit of 5.2 percent of GDP for FY09 - 0.9 percentage points higher than the targeted level.
SBP said that provisional figure of Rs 106.6 billion government borrowing from the SBP during 1st July--19th September, FY10 also indicate the extent of fiscal position's weakness in the current quarter. This borrowing was despite the fact that Ministry of Finance realised Rs 333 billion in the six Q1-FY10 T-bill auctions while adhering to an advance auction target of Rs 325 billion for the quarter.
However, this financing pressure along with recent uptick in market interest rates and liquidity tightness is largely cyclical and is mostly due to the month of Ramazan and Eid festival. Likely reversal of these phenomena along with the retirement of wheat financing and improvement in external flows is expected to improve the market liquidity in the coming months and flow of credit to the private sector.
"Sustainable recovery of real sector of the economy would not be possible without revival of business environment and availability of credit to private sector, which in turn depends on the elimination of electricity shortages among other factors," SBP said in its monetary policy statement.
Moreover, stagnant private sector investment can hurt the potential output of the economy, adversely impacting inflation persistence. However, recent steps taken towards resolution of the circular debt issue could lead to the resumption of private sector credit in the coming months.
In conclusion, there are some risks to inflation while the economy gradually stabilises. Moreover, uncertainty regarding the outcome of ongoing fiscal consolidation, resolution of electricity problem, and timing of official foreign inflows call for prudence at this point. Therefore, there will be no change in the SBP's policy rate, which will remain at 13 percent.