In its meeting held on 29th September, Monetary Policy Committee (MPC) of the State Bank again decided to raise the policy rate by another 100 basis points to 8.5 percent with effect from 1st October, 2018. Welcoming the smooth transition between governments, the Monetary Policy Statement (MPS) says that concerns on the economic front still "continue to persist on the back of rising inflation and large twin deficits that are likely to compromise the sustainability of the high real economic growth path." CPI inflation is inching up and averaged 5.8 percent during the first two months of FY19 as compared to 3.2 percent in the corresponding months of FY18 and at an average of 3.9 percent for all of 2017-18. The jump was more pronounced in the case of core inflation, a measure reflecting the underlying inflationary pressure in the economy. For FY19, the SBP expects the average headline inflation to be in the range of 6.5-7.5 percent.
GDP growth rate, after a healthy 5.8 percent in FY18, is likely to slow down in FY19, "as the general policy mix is focusing towards stabilisation" while the transmission of SBP's policy rate hike by 175 bps since January, 2018 is still unfolding. The government is pursuing a fiscal consolidation programme and has further announced regulatory measures to slow down pressures on the external sector. Cotton production is expected to miss FY19 target of 14.4 million bales with downside implications for agriculture sector as well as other ancillary services sectors. "After incorporating the latest information on both demand and supply, SBP projects the real GDP growth rate for FY19 to be around 5.0 percent," according to the MPS.
As for the external sector, the C/A deficit continues to pose a challenge. Despite some growth in workers' remittances and exports in the first two months of FY19, a notable increase in the value of imports has widened the C/A deficit to dollar 2.7 billion as compared to dollar 2.5 billion in the corresponding period of last year although non-oil imports had declined during July-August, 2018. Owing to this unhealthy development, FX reserves held by the SBP declined to dollar 9.0 billion as of 19th September, 2018 compared to dollar 9.8 billion at the close of June, 2018. While private sector credit growth is expected to continue, monetary growth is expected to remain between 10.5-11.5 percent in FY19. Keeping all the considerations in view, the MPC was of the view that further consolidation efforts are required to ensure macroeconomic stability.
Although the government and the business community may not like the increase in the policy rate, yet we feel that under the prevailing macroeconomic conditions, there was no alternative for the MPC but to opt for a handsome increase in the discount rate. Of course, no central bank can afford to reduce or keep the policy rate unchanged if inflationary pressures are building up, fiscal policy is not supportive, external sector is under a great deal of threat and macroeconomic stability is in danger to give a negative view of the economy. Although inflation is still under control, it has tended to increase in the recent months and is certainly going to exacerbate during the course of the year due to increase in international oil prices, an upward revision in gas prices, a further increase in regulatory duties on imports and substantial depreciation of the exchange rate of the rupee. If this is not enough, increase in electricity tariffs also seems to be on the cards, availabilities in the economy are going to be lower than the target as measured by the likely GDP growth rate in FY19 and aggregate demand is going to be higher due to a sizeable expansion in the private sector credit and money supply. Fiscal policy of the country is also highly expansionary leading to higher aggregate demand and putting pressures on the domestic prices. Pakistan's budget deficit had widened to a whopping Rs 2.26 trillion or 6.6 percent of GDP in the outgoing fiscal year, the highest in the five-year term of PML-N government that had initially targeted to reduce the budget deficit to 4.1 percent of GDP and then revised this target to 5.5 percent of GDP during 2017-18. The present government has taken certain measures to contain the fiscal deficit in its 'mini-budget' but these are not enough to bring a major change in the situation.
Most challenging is, however, the situation on the external front. A C/A deficit of dollar 2.7 billion during the first two months suggests that the aggregate C/A deficit during FY19 may not be very much different from the one during the outgoing year. This may be due to a surge in oil prices in the international market, protectionist trade policies and falling flows to the emerging markets. The rise in the policy rate had also become imperative to disincentivize the individuals and households to substitute their rupee holdings with foreign currencies and ensure a higher rate of return to increase the saving rate in the economy and support growth process.
It goes to the credit of the present government that contrary to the policies of the previous government, it is at least trying harder to promote austerity to reduce public expenditures, increase its revenues through higher energy tariffs, reduce subsidies wherever possible and punish the tax dodgers. It is even more serious in reducing the C/A deficit and finding ways to bridge the gap between forex expenditures and earnings. It is not even shy to depreciate the rupee further, negotiate another programme with the IMF and seems prepared to take harsh measures to stabilise the economy and put it on a growth trajectory. We know that the introduction of reform process and consequent harsh measures would be unpopular but these are almost inevitable, given the large twin deficits, uptick in inflation, and the possibility of insolvency and depressed economic activity if nothing is done to reverse the deteriorating trend in macroeconomic indicators.