The persistent inflationary pressure, combined with a premature relaxation of monetary policy, may derail the fragile economic recovery and stall economic growth. According to a report of Pakistan Institute of Development Economics (PIDE), with limited fiscal space, the onus of stimulating the economy falls squarely on monetary policy.
However, given the persistent inflationary pressure, a premature relaxation of monetary policy may derail the fragile economic recovery and stall economic growth, it said. "What is needed at the moment is prudent macroeconomic management to consolidate macroeconomic stability, on the one hand, and to address supply, on the other," the report said.
It said that the recent improvement in some macroeconomic indicators had prompted many to call for a loosening of monetary policy to revive economic growth. It is argued that continuing the tight monetary policy would unnecessarily prolong a lending squeeze and hence choke the process of economic growth. Due to a tight monetary policy under the Stand-by Agreement with the IMF for about six months the State Bank of Pakistan (SBP) has been on a path of steadily lowering the discount rate.
This revision was basically premised on 'substantial improvements' in multiple indicators, the downward trend in inflation; the improving current account balance; domestic demand contraction; and positive trends in the real sector. "The expectation that inflation would remain in single digit is, however, quite unrealistic in view of the rising international commodity prices, recent increase in domestic power and gas tariffs, and the dismal performance of the real sector.
To provide further impetus to the sluggish economy, the SBP again revised the policy rate downwards by 50 basis points to 12.5 percent in November 2009. This easing of monetary policy without taking care of supply side bottlenecks is likely to build inflationary pressures in the economy".
The report said that a look at some key macroeconomic indicators presents a worrying picture. Inflation remains stubborn even today. Inflation has receded in recent months on account of strong base effect of the fiscal year 2008-09, and this effect is expected to phase out by early 2010. Monthly Consumer Price Index (CPI) reveals a constant upward trend, though December 2009 witnessed a slight decline in the index.
The recent increase in the electricity and gas tariffs will exert an upward pressure on general price level. So, in all fairness, inflationary pressures will build up again. It is interesting to note that the present policy stance completely disregards the supply-side imperfections that inhibit price adjustments in domestic markets.
The wheat crisis during Ramazan and the present sugar crisis reflect governance issues (cartelisation, hoarding) in the domestic supply chain and cannot be tackled through monetary policy alone. The support price mechanism also needs review. Last year, the support price for wheat was fixed at Rs 950 per maund, when international wheat prices were going down, without realising its impact on inflation later on.
Further, controlling inflation has been problematic due to depreciation of Pakistani rupee, which inhibited pass-through of lowered international oil and other commodity prices to domestic consumers in the aftermath of global economic crisis. These prices are showing upward trend again; therefore, domestic prices will become under pressure even more.
The industrial production had shown some recovery during July-November 2009: the Quantum Index Number of Large Scale Manufacturing Industries [QIM] shows positive growth (0.7 percent, Y-o-Y), arresting the downward slide of the index for thirteen months in a row.
However, a combination of factors including continued power outages and tariff hike increased cost of imported raw materials, the law and order situation, and depressed external demand pose significant risks to a lasting recovery in the industrial sector.
The credit to private sector showed marginal improvement in recent months, but Y-o-Y average showed a contraction of three percent in credit off-take during November. Though total domestic credit expanded by eight percent, the expansion was accounted for by increased allocation of resources for government budgetary support; thus crowding out credit to private sector.
Current account balance showed remarkable improvement in the first quarter of fiscal year 2009-10, declining to $532 million from $4.26 billion during the same period a year ago. In fact, the deficit narrowed down from its peak in October 2008 to post a surplus in September 2009.
There are two warning signs in this development. First, much of this improvement owes to a surge in the foreign remittances. Questions arise regarding sustainability and origin of this unusual phenomenon. Second, trade gap is beginning to widen again as import growth has outstripped growth in exports in December 2009 on a year-on-year basis.
Import of textile machinery has taken a hit, which was 32 percent lower for July-November 2009 as compared to the same period the previous year, implying sluggish economic activity in our main export sector. High cost of inputs, power crisis and dampened external demand pose substantial barriers for rapid recovery of exports. Meanwhile, imports are likely to increase due to upward trend in the oil and other commodity prices, and expansion in domestic demand.
Pakistan's external liabilities soared by almost US $3 billion during the first quarter. This does not augur well for the fiscal balance in future. If the increase in external debt remains consistently unmatched by GDP growth and foreign exchange earnings, then Pakistan may once again face debt servicing difficulties, similar to that of the late nineties, when a major part of taxation revenues were being eaten up by debt servicing.
This complexity is compounded by the fact that foreign direct investment has dried up due to weak economic growth globally and law and order situation in Pakistan. On the whole, the economy continues to face problems on internal as well as external front. Internal structural problems persist in the form of power shortages, law and order situation, and absence of domestically garnered resources.
External situation is not optimistic as global economic recovery continues to remain weak, not boding well for exports and availability of external finance. Overall, persistent inflation, sluggish activity in the real sector, internal security environment and weak recovery in the global economy present a challenging environment for reviving growth.
"Yet there is a silver lining on the horizon as the emerging macroeconomic stability would help improve macroeconomic fundamentals and restore investor confidence thus providing a basis for durable recovery. However, a balancing act is required on the part of the government to keep its stabilisation policies on track while giving impetus to economic activities".