In its meeting held on 30th March, 2018, Monetary Policy Committee (MPC) of the State Bank has again opted to keep the policy rate unchanged at 6.0 percent per annum for the next two months. Justifying its stance, a press statement issued by the State Bank says that "the prospects of achieving an eleven-year high growth rate remain strong with average headline inflation within comfortable bounds for FY18 and FY19". However, this has been accompanied by a higher current account deficit and along with a high fiscal deficit, this could affect medium term stability of the economy. Nonetheless, greater exchange rate flexibility, active monetary management, improvement in exports and home remittances are expected to bear fruit in terms of growth momentum without posing a risk to stability.
CPI inflation had remained moderate so far, averaging 4.1 percent during Jan-Feb, FY18. Going forward, sticky core inflation alongwith a moderate outlook for food prices and the recent increase in policy rate are expected to contain average inflation well below the target of 6.0 percent in FY18 and close to this level in FY19. Real sector is progressing well. Agriculture sector, despite some shortfall in cotton production, is projected to post a positive growth for the second consecutive year and LSM growth is expected to maintain its current momentum in the remaining months of FY18. On the monetary front, there has been a relative improvement in financial intermediation. Sustained growth of private sector credit flows had reached Rs 354 billion during July-February FY18 as compared to Rs 338 billion in the same period of FY17. Given the favourable economic outlook, growth in private sector credit is expected to maintain its momentum throughout FY18 and well in FY19.
On the external side, exports during Jul-Feb, FY18 have soared by 12.2 percent as compared to the decline of 0.8 percent in the same period of last year. Workers' remittances have recorded a growth rate of 3.4 percent so far despite a fall in manpower export. However, import growth has remained high despite higher regulatory duties and exchange rate movements. As a result, current account (C/A) deficit reached dollar 10.8 billion during Jul-Feb FY18, which was about 50 percent more than what it was during the same period of last year. Financing of this size of C/A deficit is challenging as growth in FDI and higher official inflows are insufficient to finance this deficit. Consequently, foreign exchange reserves held by the SBP fell to dollar 11.78 billion as of 22nd March, 2018. Going forward, along with a focus on narrowing the C/A gap, the government plans to mobilise external inflows, both official and commercial, to maintain adequate levels of foreign exchange reserves.
Although the MPC has tried to give a positive spin to the variables affecting its policy decision, it is quite clear that, under the circumstances, it would have been better to raise the policy rate somewhat, say by another 0.25 percentage points or so. Demand pressures in the economy are building up and these could be only contained by tightening the monetary policy as fiscal policy of the country is certainly going to be expansionary in view of the coming elections and the government's desire to woo the electorate. The volatile global oil prices and the recent depreciation of Pak rupee amounting to nearly 10 percent would also play their part in pushing up the inflation rate in the coming months. So far as availabilities in the economy are concerned, it would be almost impossible to maintain the present growth rate due to a dismal saving rate in the economy which could further be depressed if interest rates in economy are not increased. A low interest rate environment would also encourage the households to invest in speculative activities like real estate and stock-exchange which are not that productive. Although the MPC has said in the very beginning of the MPS that a higher current account deficit together with high fiscal deficit could affect medium-term stability of the economy, the State Bank has refrained from raising the policy rate probably in order to fully see the impact of the rise in the policy rate in the previous review and the recent depreciation of the rupee against the US dollar on inflation, monetary statistics, growth and external sector accounts. This is borne out by the observation in the last paragraph of the MPS that "following detailed deliberations, the MPC is of the view that some time may be allowed for the impact of recent policy developments to unfold and has therefore decided to maintain policy rate at 6.0 percent for the next two months."
The most convincing reason for raising the policy rate, in our view, was the worsening position of the external sector which, according to the MPC, is a challenge to finance. Last year, the C/A deficit was over dollar 11 billion and this has already soared to dollar 10.8 billion during the first eight months of FY18, suggesting that it could be nearly dollar 16 billion during the current fiscal. Consequently, foreign exchange reserves of the country are decreasing continuously; these stood at only dollar 11.78 billion on 22nd March, 2018 which are equal to only 2 to 3 months of imports. The MPC is of the view that the government may be able to mobilise external inflows, both commercial and official, to maintain adequate levels of foreign exchange reserves but such a strategy has its weaknesses. These borrowings would be very expensive for the country due to poor credit rating and cost the country dearly in terms of debt servicing. By keeping the policy rate unchanged, the SBP has also made the holding of rupees less attractive than foreign currencies, exacerbating the external situation further and putting more pressure on the rupee rate. It looks that MPC was fully aware of all the relevant factors but has preferred to adopt a "wait and see" attitude before making the next move.