Feb 16 - 22, 2009

The macro fundamentals under the successful implementation of IMF program has brought tremendous ease for the central bank which is most likely to announce an aggressive cut tentatively 400bp in the policy rate on April 30, 2009.

Sayem Ali, the Economist of Standard Chartered bank in his  analysis of the prevailing economic situation observed that on 31 January, the central bank kept the policy rate on hold at 15%, in line with market expectations. Significant improvement in all key economic indicators and success in meeting IMF programme targets meant that the central bank was no longer under pressure to raise the policy rate (under the IMF programme, the authorities had committed to raising the rate if targets were not met). In its Q1-2009 Monetary Policy Statement (MPS), the central bank indicated that inflationary pressures are subsiding due to corrections in the fiscal and external accounts. The balance-of-payments account recorded a surplus in December 2008, the first in 18 months, as record-high remittances and FDI inflows helped FX reserves surpass USD 10bn.

All indicators point towards greater stability in 2009, and we expect the central bank to cut the policy rate by 100bps in its next MPS, scheduled for end-April 2009. We stick to our call that the policy rate will be cut to 11% by the end of 2009. However, the uncertain political and security environment, coupled with the global recession, poses downside risks to macroeconomic stability.

Record-high remittances and FDI drive BoP surplus The December 2008 balance-of-payments account registered a surplus for the first time in 18 months due to a falling import bill and record-high remittances and FDI inflows. Despite the global financial turmoil and credit crisis, private FX inflows into Pakistan remained robust. The build-up of FX reserves on account of the IMF loan, a stable PKR, and declining inflation has restored confidence in the economy and attracted FX inflows, particularly from the overseas Pakistani community. Remittances registered growth of 40% y/y in December 2008 as high interest rates and a stable PKR encouraged repatriation of income by overseas workers. Remittances in 2008 topped USD 7bn, an increase of 17% y/y, led by higher remittances from oil-rich GCC countries, which grew by 30% y/y. Similarly, FDI inflows jumped 100% y/y to USD 708mn as the telecom, oil and gas, and financial-services sectors continued to attract foreign inventors. The deregulation and privatisation process undertaken over the past eight years has attracted investment to these sectors. FDI inflows in 2008 stood at USD 6.2bn, an increase of 4% from USD 6bn in 2007. The outlook for H2-FY09 (January-June 2009) is even better. The central bank projects that the current account deficit will shrink to USD 3.9bn for the six-month period, from USD 7.3bn in H1-FY09. This will help FX reserves to exceed USD 13bn by the end of June 2009, compared to USD 10.2bn at the end of January, according to the central bank.


The stabilisation programme envisaged a significant tightening of fiscal and monetary policy to bring down inflation and reduce the external current account deficit to a more sustainable level. Under the IMF programme, the central bank had 'committed to increasing the discount rate further' if official FX reserves fell short of the programme target and if the government was unable to meet its Q4-2008 deficit financing through the sale of market securities at current cut-off yields. Achieving these targets required major corrections in the fiscal deficit and the balance-of-payments account. The targets for the end of December 2008 were met comfortably thanks to prudent fiscal and monetary policies, aided by the fall in international commodity prices. Falling food and petroleum prices have not only brought the import bill down sharply, they have also allowed the government to reduce subsidies and increase tax revenue from the collection of the petroleum development levy (PDL). This capped the fiscal deficit at 2% of GDP in H1-FY09, thereby also reducing the government's deficit financing requirements. The fiscal deficit was financed through successful auctions of Treasury bills, with the government raising PKR 323bn, against a target of PKR 290bn. This helped the government retire its debt to the central bank and meet its December 2008 programme targets.



IMF programme targets






Floor on net foreign assets of SBP (USD mn)






Ceiling on: (PKR bn)

Net domestic assets of SBP






Budgetary borrowing from SBP






Fiscal deficit






Source: IMF Staff Report December 2008, SBP

Interest rate cycle has peaked; rate cut anticipated in April 2009 The key message of the latest MPS is that the interest rate cycle has peaked and the central bank will cut rates as inflationary pressures subside. A stable PKR has helped to transfer lower international commodity prices to domestic consumers. Zero net fiscal deficit financing by the central bank during Q2-FY09 (October-December 2008) has helped to arrest growth in the money supply, which will reduce demand-side inflationary pressures going forward. Hence, we foresee inflation declining sharply from Q2-2009 and reaching single digits by the end of 2009. Another leading indicator of subsiding inflationary pressures is the sharp fall in the wholesale price index (WPI) inflation rate. Year-on-year wholesale price inflation fell below consumer price inflation for the first time in 18 months. This is an indication that output (consumer) prices are under less pressure to adjust to input (wholesale) prices. Given these developments, we anticipate a rate cut of 100bps in April 2009, followed by more aggressive cuts from H2-2009. We maintain our call that the policy rate will be reduced to 11% by the end of 2009.

Reviving growth The economy is grinding to a halt; data for the manufacturing sector indicates that output declined by 5.6% y/y during the first five months of the current fiscal year (July-November 2008). Exogenous price shocks (oil and food), debilitating power cuts, and the deteriorating security environment in the North West Frontier Province (NWFP), which contributes 10% of national GDP, have led to falling domestic output.

The central bank projects that growth will slow sharply for the full fiscal year to 3.5%, the lowest level in eight years. While manufacturing-sector growth will likely remain weak in 2009, overall growth will be driven by a robust services sector (which contributes nearly 50% of GDP) and a strong turnaround in the agricultural sector, with bumper wheat and rice crops expected to boost output. However, given the weak H1-FY09 industry performance, we believe that the full fiscal year growth will print lower at 3%. Total investment in the economy has continued to decline and is projected to fall to 20% of GDP in FY09 from 21.3% in FY08. Consumption is declining due to high inflation, high interest rates, and rising unemployment. Private-sector credit declined sharply during H1-FY09 to PKR 122.3bn, down 54% from PKR 268bn in H1-FY08. Weak external demand will slow export growth. Given these concerns, we expect the central bank to take proactive measures to support growth in 2009. Increasing banks' limit under the subsidised Export Finance Scheme (EFS) and Long Term Financing Facility (LTFF) by PKR 35bn is a step in the right direction, and will reduce financial costs for the export industry. However, until interest rates are reduced, banks will remain reluctant to lend to the private sector amid concerns over rising non-performing loans.

The risks While indicators such as rising reserves and slowing inflation point to greater stability, political uncertainty, deteriorating security conditions, and the fallout from the global recession pose risks to the macroeconomic outlook. Political noise is rising ahead of Senate elections scheduled for March 2009. The People's Party (PPP) and the Muslim League (PMLN), the two political heavyweights and former coalition partners, have been unable to resolve their differences on policy matters related to the war on terror, the restoration of deposed judges, and the abolition of President Musharraf's 17th amendment, which shifts the power to make key government and military appointments from the prime minister to the president. PMLN's decision to support street protests by lawyers against the PPP-led government will raise the political temperature and could potentially destabilise an already fragile situation. The security environment has also continued to deteriorate, especially in the troubled NWFP province. The uncertain political environment and security threats pose a challenge to the government's efforts to maintain fiscal discipline and meet the targets set under the IMF programme.

In addition, the global financial crisis and recession will have negative consequences for the domestic economy. Weak external demand in Pakistan's main export markets, including the US, EU, and Japan, will negatively impact exports, particularly the textile sector, which accounts for 60% of export receipts. Similarly, private FX inflows, including remittances and FDI inflows, are expected to slow in 2009 given the turmoil in global financial markets.