The State Bank of Pakistan (SBP) cautioned on Thursday that foreign exchange reserves could decline considerably in the second half of the on-going fiscal year, if the budgeted foreign inflows did not materialise.
Briefing the Senate Standing Committee on the state of the economy, officials of the SBP said that net capital and financial inflows during the first five months of the current fiscal year amounting to $213 million have been insufficient to finance the widening current account deficit, which increased pressure on foreign exchange reserves and exchange rate.
The likelihood of a sharper fall in foreign exchange reserves is strong in the second half of 2011-12 on account of large repayments of external debt, including $1.2 billion of IMF loan. The current account deficit could escalate to 2.5 percent of the GDP, replied the official to a query.
The timely materialisation of the planned official inflows is essential to avert pressure on foreign exchange reserves, he said that Foreign Direct Investment (FDI) was only $370 million during the first five months of the current fiscal year and other financial inflows including official inflows were also low.
To overcome the current macroeconomic challenges, the SBP has suggested the government to ensure that all or major parts of budgeted foreign inflows materialise. Additionally, the government should initiate comprehensive tax reforms to broaden the tax base and improve financial deepening, increasing competition in the banking system.
The officials stated that the risks to macroeconomic stability was emanating from fiscal weaknesses and decreasing foreign financial inflows and despite reduction in policy rate, private sector credit has not picked up accordingly which reinforces the view that unless investment climate in the country improves policy incentives are likely to be less effective.
Inflation, according to SBP, declined in December 2011... but core and trim inflation is sticking over 10 percent with more inflationary pressure emerging from possible fiscal deficit, budgetary borrowing and deterioration in balance of payment. The annual target of inflation is likely to remain close to 12 percent.
The recent decline in inflation was largely on account of fall in food prices and CPI is considered still on the high side at the current level because more than 50 percent items in the basket are showing double-digit inflation. The GDP growth is expected to remain around 3.8 per cent from budgetary target of 4.2 per cent for the current fiscal following damage to the agriculture sector by floods for the second year in a row.
The estimate of cotton production has been scaled down by 2 to 2.2 per cent for the current fiscal year due to damage floods caused to the agriculture sector. The decline in investment from the last two years was a matter of grave concern.
About the trend in current account deficit, the SBP informed the committee that current account deficit widened significantly to $2.1 billion against a deficit of only $0.6 billion in the first five months of the current fiscal year while trade shock has significantly contributed to deterioration of trade balance with significant decline in export growth owing to fall of cotton prices in the global market and high imports growth on account of elevated oil and fertiliser prices.
On the fiscal side, the officials said fiscal deficit of 1.2 percent of GDP during the first quarter of the current fiscal year was lower compared to 1.5 percent for the same period of last year but was not in line with budget target of 4.0 percent and may go over 6 percent.
The heavy reliance on baking system to finance the fiscal deficit was crowding out the private sector and complicating liquidity and monetary management. The government borrowing from scheduled banks has reached Rs 648 billion by December 15, 2011 as compared to Rs 96 billion for the same period last year, and even after excluding Rs 391 billion, used for the settlement of circular debt, borrowing is very high. According to the SBP short-term borrowing is increasing rollover risk and interest rate risks for public debt.
On expenditure side, the SBP said the untargeted subsidies are major burden on current expenditure. The development expenditures, the officials said are crucial for productive capacity and growth but these were continuously declining. One reasons for low investment is declining size of the PSDP. The Senate standing committee was informed that deterioration in the external account balance and increased government borrowing from scheduled banks squeezed the money market rupee liquidity which was increasing pressure on the money market overnight repo rate.