TIME TO RATIONALIZE DISCOUNT RATE

SHABBIR H. KAZMI
Jan 26 - Feb 01, 2009

The newly appointed Governor, State Bank of Pakistan is expected to announce January-June 2009 Monetary Policy Statement by the end of this month. A lot of loud talk is going whether he would be able to convince others that the country needs easing of the policy or would he be forced to continue a policy being followed by his predecessor? It seems most likely that there would not be any further hike in discount rate even if reduction in interest rate is opposed by some of the quarters.

The admirers of International Monetary Fund (IMF) are saying that with the initiation of the IMF-backed economic stabilization program, there has been a gradual and persistent movement towards macroeconomic stability. This is visible from the ongoing correction in external imbalances, downward inflationary trend and improvement in the central bank's foreign exchange holdings. It is partly true because the real difference has been made by the massive decline in the prices of crude oil, wheat, fertilizer and reduction in imports. However, the IMF assistance has removed fear of Pakistan's potential default in its debt servicing obligation and also eased pressure on exchange rate.

Keeping in mind that the ongoing rationalization in inflationary pressures and balance of payment is likely to accelerate during second half of the current financial year, there is space for a potential cut of over 100bps in the policy discount rate. At the same time, a sustained reversal in global commodity prices is likely to further ease the pressures on foreign exchange reserves and exchange rate. With Pakistan heading towards macroeconomic equilibrium, an eventual reduction in interest rates should help reinvigorate flagging real GDP growth in the near future.

With the ongoing decline in imports due to economic slowdown and the prevailing slump in global commodity markets, the correction in Pakistan's external imbalances is expected. This process is expected to gain further momentum and likely to reverse the earlier depletion in the country's total foreign exchange reserves, currently reported around US$10 billion. Considering that Pakistan will be getting additional US$1.5 billion from the IMF and a similar amount from China and the World Bank during January-June 2009, the balance of payment issue seems to have been resolved, at least for the medium term. In this background, the exchange rate is expected to further stabilize in short to medium term.

As inflationary expectations rationalize and the economy re-equilibrates, a reversal in the monetary stance seems possible. This perception is supported by the improvement in the SBP's NFA position since Dec'08, which augers well for the central bank to meet its monthly foreign exchange reserves targets on which the direction of the monetary policy currently hinges. An easing of the SBP's monetary stance ought to stimulate real GDP growth onwards and at the same time ease the prevailing liquidity crunch in the financial sector.

The central bank has been a target of criticism for raising its key policy rate by 5.5 to 15 per cent since July 2007. It has been argued that the rising interest rate has sharply increased the cost of doing business and made the exports uncompetitive in the international markets at a time when the global demand is receding owing to financial crisis followed by severe economic recession in the developed economies. The critics demand that the bank should adopt an easy monetary stance to restore competitiveness of the local manufacturers for accelerating GDP growth rate.

Yet there are economic experts who still anticipate further increase in the central bank's discount rate, though for different reasons. Dr Hafiz Pasha, who heads the Panel of Economists that drafted Macroeconomic Stabilization Plan, told a seminar recently that there exists a possibility of rise in the central bank's policy rate in the coming days. In his opinion core inflation is showing no signs of let up and there is yet no end of impact of hangover of unprecedented monetary expansion in the previous year. He also did not rule out the rupee coming under more pressure in the coming weeks as oil transactions have to be market-based under the IMF loan conditions. One needs to understand time lag phenomenon. It also does not make much difference whether dollars are supplied by the central bank or bought from the inter bank market.

There are others who warn against making any 'positive or negative' forecasts on the basis of economic data available for the first half of the year. 'It is too early to say anything at the moment. If we want to make any reasonable assessment of the state of the economy and predict future trends, we should wait for the economic data for the third quarter of the current financial year to March. That will tell us the direction of domestic and global trends and help in forming a realistic assessment of the economy. Why wait till March end?

Some economic experts also agree that inflation has come down but don't yet know if it represents a long-term trend or it is a temporary phenomenon. Similarly, the current account gap for the first half was $7.2 billion. They are not sure how much the reduction in global commodity prices is going to help bridge this gap as exports are also slowing down on account of international recession. Wheat, fertilizer and crude oil have been the significant contributor to import bill.

One fails to understand that instead of government's functionaries convincing the IMF about the improving macro economic indicators have become devil's advocate. The role of elected representatives is also deplorable because they have consented to cut in PSDP allocations but are also indulging in extravaganzas. The lavish spending is evident from rising domestic debt, which exceeded Rs 3.5 trillion at end November 2008.