Nov 19 - 25, 2012

In the recent past the State Bank of Pakistan has cut the discount rate because the macroeconomic indicators supported the move. However, there are concerns that no more reduction in policy rate will be possible because the indicators show the opposite. Overall foreign reserves of the country are on the decline, budget deficit is on the rise and energy crisis is likely to get worse. There are concerns that the incumbent government is failing in taking timely action to avert the adverse impact of rising crude oil prices in the global markets. It has also failed in containing load shedding spells of electricity and gas.

Lately, the SBP slashed the discount rate by 50bps, which was expected to bode well for country's economy. The decision has attracted mixed reaction from trade and industry as well the experts. However, there was growing consensus among the experts that no more reduction in interest rate may be possible in the future and the central bank will be forced to raise the rate. While every one wishes these apprehensions prove wrong, there is a dire need to take corrective steps to keep the economy on track.

The general expectations was the SBP should cut the minimum by 50bpsif it was serious in accelerating GDP growth or take the bolder step of cutting the policy rate by 100bps, the central bank opt for a rather cautious approach. Earlier, the discount rate was slashed by 150 bps. The rate cut decision was driven by inflation rate running into single digit and slight increase in foreign exchange reserves but there are growing apprehensions that inflation rate will soon run into double digits. This cynical reaction is based on the apprehension that the government has failed in resolving the circular debt issue and the country will witness even prolonged outages of electricity and gas with the commencement of winter season.

It may be true that the outlook does not look very rosy but a lot depends on ability of the government and the private sector to efficiently and effectively benefit from this short lived opportunity. Rate cut bodes well for textiles and clothing industry as well as the cement sector. The added plus points are reduction in export refinance rate for the textile sector and declining trend in coal prices. However, this opportunity will no longer be available once load shedding spells of electricity and gas start getting longer.

There are two immediate concerns 1) likely increase in cotton prices in the domestic markets and 2) fall in cement offtake during winter. Therefore, much will depend on how prices of these products move in the international markets. Historically, hydel power generation goes down in winter die to water in dams touching 'dead levels'. However, this year not much of support can be expected from thermal power plants, suffering from acute liquidity crunch diminishing their ability to purchase furnace oil on borrowed money.

During the ongoing financial years the government is not likely to reduce its borrowings or sharply improve its revenue collection to contain budget deficit. The central bank has also asked the commercial banks to mobilize more deposits to facilitate lending to private sector. As a first step, the SBP has told the banks that they would not be able to use their held to maturity (HTM) bonds to Repo with SBP, after October 19. The central bank has injected over Rs600 billion through open market operations (OMOs) into the system. Anywhere from Rs 350 to 500 billion is a permanent injection of liquidity. Out of Rs2.5 trillion in government issued securities out of this around Rs359 billion or more is said to be classified as HTM.

The SBP policy regarding HTM bonds is more likely to restrict ability of small and medium sized banks to use the SBP window for borrowing funds. As a consequence, the overnight interbank borrowing rate would rise. Big banks also hold huge quantum of HTM bonds. However, their percentage is much less than their total bond holdings. Their investment in government paper is now around 50% of their deposits. Therefore, they would still be able to avail the SBP facility the need to borrow arises.

One of the suggestions is that the SBP withdraw minimum payment of 6% interest to the depositors, which allows the banks to earn 7.5% on their excess funds left with the SBP overnight. This would be an inducement to big banks to repo or do short-term borrowing in government securities with other medium and small banks, instead of the SBP. If the central bank concedes to this demand, it will be injustice with deposits because banks are paying huge salary to staff and dividend to shareholders but exploring opportunities to cut return being paid to depositors on one or the other pretext.

The real worry is that the ongoing going year is likely to be the election year and the coalition government would insist on bringing down interest rate further to spur growth. Even though central banks normally do not look at month-to-month inflation as they look at year-on-year inflation, plus on core and trim bases, average inflation for 2012-13 is likely to remain in single digit. However, the real problem the SBP is faces is eroding exchange rate. The regrettable point is that some of the experts believe even if exchange rate drops to Rs100 to a dollar, it should not be a point of concern. May be this proposal is being pleaded by exporters but the reality is with dollar becoming expensive everything becomes expenses.

In the recent past Pakistan's current account was fully supported by record inflow of remittances. However, it is feared that any decline is remittances will not bode well for the country. Remittances are expected to aggregate to over US$15 billion by end June 2013. Payments on services account could also be lower but softer oil prices would be helpful. In the short-term, the current account deficit would definitely be better than last year's despite lumpy payments to the International Monetary Fund. Once the US elections are over, in November, the uncertainty over Iran and Syria would also hopefully be cleared. Depletion of foreign currency reserves by mid 2013 remains a serious concern.

The International Monetary Fund (IMF) has reportedly shown its displeasure on Pakistan's performance with respect to stabilization of the economy and projected fiscal deficit above 6% for the current fiscal year against 4.7% budgeted by the economic team. Sources said that an IMF delegation led by the country director Jeff Franks appeared worried during two-day policy-level talks on Post-Program Monitoring (PPM) of the Stand-By Arrangement (SBA) regarding Pakistan's fiscal framework in the face of growing gap between expenditure and revenue. The Fund also expressed reservations regarding economic team's projections of revenue collection of Rs2.381 trillion, arguing that revenue collection for the current fiscal year could at the best reach Rs2.2 trillion.