The State Bank in its Monetary Policy Statement (MPS) released on 20th September, 2014 once again decided to keep the policy rate unchanged at 10 percent. In announcing the decision, however, the SBP has mainly factored the emerging risks to the economy into formulating a monetary policy stance rather than the actual current economic indicators, which would have warranted a downward revision in the policy rate. Clarifying its position, the State Bank has stressed the point that the economy continues to witness stable macroeconomic conditions at present, with the headline inflation dropping to 7.4 percent in the first two months of the current fiscal year as against 8.6 percent in FY14. The current inflation outlook of around 8 percent during FY15, nonetheless may change adversely if the subsidy to electricity is cut and Gas Infrastructure Development Cess (GIDC) is levied. After demonstrating low growth since 2008, real economic activity had started to show signs of revival in FY14 but the momentum of growth hinges primarily on agricultural production in 2014-15. Ongoing political impasse, delay in the finalisation of fourth IMF review and current heavy rains and floods engulfing central and southern Punjab threaten the nascent recovery in economic activity. "Besides having implications in economic growth, floods can also create macroeconomic imbalances by putting pressures on fiscal and external sector," the MPS goes on to say. The supply of available funds in the credit to private sector market may also be adversely affected.
State Bank is also not optimistic about the external sector developments. Incorporating the latest trends in exports and imports, trade deficit is going to dominate the composition of current account deficit, even with a healthy growth in workers' remittances. Declining private capital inflows and foreign direct investment would also present challenges in managing the balance of payments position. Reflecting all these apprehensions, there was deterioration in the SBP-IBA's Consumer Confidence Survey of September, 2014 as well. According to the State Bank, "policy vigilance requires balancing the trade-offs between ensuring the continuation of macroeconomic stability, especially in the external sector, and assuaging the fallout of potential damages due to floods."
Though the business community had made a pitch for easing of monetary policy due to softening of inflation, build-up of foreign exchange reserves and stability in the exchange rate during recent months, the State Bank decided to continue the policy rate of 10 percent. This, in our view, is entirely justified due to growing risks to the economy that are quite obvious by now but would show up in quantitative terms only after a few weeks. In order to ward off criticism likely to be levelled against its cautious policy stance, the SBP has stressed the point that although low inflation during July-August, 2014 might weigh positively on market sentiments, it was the future path of inflation that matters for monetary policy decision. Looking closely, most of the relevant indicators, as expected by the SBP, are likely to be adversely affected by the persistence of the current political impasse, a reluctant attitude of the IMF, heavy rains causing floods, etc, that are going to pose challenges of varying degrees in every relevant field. Availabilities in the economy as measured by the GDP growth rate are likely to be much less than the target fixed in the beginning of the year largely due to the devastation caused by floods spreading over large parts of the country. Standing crops that have suffered damage include cotton, rice, sugarcane, vegetables and, certain minor crops that would not only have a direct bearing on the country's net export earnings but also feed inflationary pressures. Dr Hafiz Pasha, a noted economist and former finance minister of the country, has estimated provisional losses between Rs 500-600 billion and the reduction of GDP growth rate to only 2.5 percent during FY15 as against the target of 5.1 percent. Lower tax revenues due to shrinkage of economy and higher expenditures necessitated by North Waziristan military operation and the rehabilitation of flood victims are likely to jeopardise the budget outcome and increase unemployment and poverty. High fiscal deficit leading to excessive money creation and slower than projected growth rate are bound to worsen the inflationary outlook. External sector balance which was not a cause of worry in the past is also likely to come under renewed pressure due mainly to widening of trade deficit. Current account balance has already posted a deficit of dollar 1.372 billion during July-August, 2014 as compared to the deficit of only dollar 580 million in the corresponding period of last year, depicting a huge increase of dollar 792 million or 136 percent. Since all those factors are very relevant and crucial to monetary policy formulation, State Bank is going to face a tough time in the coming months to balance the objectives of growth and price stability. The possibility of a monetary policy tightening in order to check inflationary expectations cannot be ruled out to protect the vulnerable sections of society.
While there were valid reasons for the SBP to maintain the status quo, the remaining part of the current fiscal is going to be a very testing time for monetary policy formulation, particularly if trade and industry continue to plead for a policy rate cut and the government follows a lax fiscal approach. Unfortunately, signs are ominous as the government, faced with excessive demands for expenditures and hostile political environment is not likely to meet the fiscal targets and may be forced to meet its additional budgetary requirements from the banking system. In case such a scenario develops, which is all but certain, it would be a tough call for the SBP to maintain financial stability as it would also be called upon to shoulder a burden of a loose fiscal policy. Although the authorities are obliged to reduce the fiscal deficit substantially under the EFF arrangement with the IMF but, speaking honestly, it is extremely difficult for the government to take necessary harsh measures in the current political environment and satisfy the Fund authorities. However, while the fiscal strategy is not likely to be supportive, the State Bank could, in the meanwhile, undertake some in-house measures and remove certain distortions, which have lately crept into the money market and debt management. For instance, the players in the financial market are now avoiding the holdings of short-term treasury bills and have joined into a stampede to hold PIBs of longer tenors. Such a move could easily be explained by the lure of higher returns on PIBs that now offer about three percent higher returns than the T-bills. This has increased the banks' appetite for easy money, raised the government's debt servicing cost, and decreased the banks' willingness to increase exposure to the private sector. It is time for the central bank to discourage commercial banks from this practice by taking appropriate measures and encourage them to play a more proactive role in financial intermediation between savers and investors in the private sector. Anyhow, while appreciating the tendency of the State Bank not to bow to the pressure groups to ease monetary policy, we will remind the SBP about its promise to publish the summary of the minutes of Board meetings on monetary policy. Hopefully, the State Bank would fulfil its commitment and by doing this would give outsiders a chance to be more familiar with the process of monetary policy formulation and the relevant variables, which serve as an input into such an exercise.
The SBP directors have not talked about an 800-pound gorilla impacting country's fiscal and monetary policy, ie, the Fund Programme. Certain commitments have been made, which remain unfulfilled as of date. Thus, the delay in the IV Review and the receipt of fifth tranche is bound to have adverse impact. How things could play out between now and December needed to be part of SBP's statement. After all, the cap on SBP's lending to the government and, the floor with regard to our forex reserves as agreed with the Fund does influence our policy decisions.