Faced with rising inflation, persistent government borrowing and deteriorating macroeconomic imbalances, the State Bank of Pakistan raised its policy rate by 50 basis points to 13.5 percent, its second successive hike, and estimated that economic growth for the current fiscal year may fall to 2.5 percent from an earlier target of 4.5 percent.
This decision was taken at a meeting of the Central Board of Directors of the State Bank of Pakistan held under the chairmanship of SBP Governor Shahid H. Kardar in Karachi on Wednesday. Increase in key policy rate is against the market expectations, as market was expecting no change in key policy rate, while this is the second increase in key policy rate during the current fiscal year as in the last monetary policy statement interest rate was also increased by 50 basis points to 13 percent.
With current surge in key policy rate the SBP Overnight Reverse-Repo (Ceiling) rate been increased from 13.00 percent to 13.50 percent per annum, while the SBP Overnight Repo facility will be available at 10.50 percent, and this will serve as the ''Floor'' for the Interest Rate corridor as announced by the above referenced circular. Hence, the Floor and Ceiling levels for the interest rate corridor are 10.50 percent and 13.50 percent pa respectively (ie width of 300 bps) and these changes are effective from September 30, 2010.
The monetary policy stance is formed by the consideration that the impact of continued inflation is substantial and felt by the entire economy, and a tightening of the stance is thus called for in full recognition that the difficulty to contain fiscal deficit has resulted in the private sector bearing the full brunt of such an adjustment, the SBP said.
According to State Bank''s post-flood projections raise legitimate concerns about the worsening of the macroeconomic balances since the initiatives required to address the underlying cause for the primary stimulus to aggregate demand, coming from the fiscal side, have yet to be launched with vigour and coherence.
"They show that inflation will increase further, accompanied by a drop in economic growth. Both the trade balance and fiscal accounts will be under stress, and the banking system may witness pressure on account of rise in NPLs of the private sector and borrowings of the government, unless a comprehensive and co-ordinated response is developed to meet these challenges," it added.
The monetary policy stance is formed by the consideration that the impact of continued inflation is substantial and felt by the entire economy. A tightening of the stance is thus called for in full recognition that the difficulty to contain fiscal deficit has resulted in the private sector bearing the full brunt of such an adjustment," the State Bank explained the rationale behind the increase in policy rate in its Monetary Policy Decision.
It said that the next quarter will be crucial in forming an assessment of the effectiveness of government efforts to contain the fiscal deficit and its inflationary borrowings from the SBP and the banking system. The SBP has also warned that increases in electricity prices, induction of the ''reformed GST'' and continued reliance of the government on borrowings from the SBP would only add to the uncertainty surrounding inflation expectations.
"The recent catastrophic floods have serious implications for macroeconomic stability and growth prospects. However, even before the floods, the macroeconomic conditions and outlook were looking fragile" the Monetary Policy Statement of SBP said. Nevertheless, the components of the economic strategy that would need to continue to be in focus despite uncertainty would include implementation of tax reforms to enhance the much-needed revenues, resolution of the energy sector subsidies and circular debt to restore economic growth, relief measures for those affected by the floods, and containment of government borrowing from SBP to restrict inflation.
Committed and credible progress on these fronts will be critical for reviving confidence and stability and stimulating economic growth, otherwise the burden of any adjustment will continue to fall on the engine of growth, the private sector. Given the scale of the devastation caused by the recent calamity, it is difficult to fully and accurately determine the extent of damage to the economy. Losses in agriculture and infrastructure are more direct and visible while the impact on industry and opportunities for the work force is going to be indirect and nuanced.
Highly provisional estimates suggest that economic growth for FY11 could come down to 2.5 percent from an earlier target of 4.5 percent. While aggregate private consumption may decelerate as a result that of the government will most likely increase to meet the urgent needs of the flood victims and their rehabilitation, leading to a sharper deterioration of the fiscal accounts.
These steps would remove any ambiguity arising from the pre-flood budget for FY11, which initially announced a deficit of 4 percent that shot up to 5.2 percent of GDP after the combined provincial budgets were unveiled. How the fiscal policy response to the floods is incorporated in the revised budget remains to be seen, but it is clear that even attaining the deficit of 5.2 percent of GDP will require considerable adjustment in the key fiscal parameters.
This entails substantial risks to economic stability in the immediate future and places a considerable pressure in the medium term on the already high debt burden of the country, the SBP said, adding that rising NPLs and relatively low private sector credit demand may incentivise the already risk-shy banks to meet government''s borrowing requirements at the cost of private investment in the economy. This could make the task of reviving economic growth and bringing inflation down to single digit level much more difficult.
The dependence on foreign borrowings has also increased due to continuous decline in domestic national savings and private foreign investments in the country. The substantial narrowing of the external current account deficit in FY10 provided some breathing space. After registering a reduction of 2.3 percent in FY10, imports seem all set to grow significantly, especially after the floods, and may post a double-digit growth in FY11.
Although the growth in exports was also projected to increase in FY11, the recent floods and the resulting disruption in productive activity could act as a dampener if the damage to the cotton crop turns out to be extensive, the SBP said.
Thus, the expected increase in the external current account deficit and uncertain foreign inflows could put pressure on SBP''s foreign exchange reserves and exchange rate in FY11. "The next quarter will be crucial in forming an assessment of the effectiveness of government efforts to contain the fiscal deficit and its inflationary borrowings from the SBP and the banking system. On its part, the SBP is raising its policy rate by 50 basis points to 13.5 percent with effect from 30th September 2010," the central bank said.