Monetary policy is aimed at curbing depreciation of rupee and containing inflation


Sep 20 - 26, 2004





Lately Pakistan has been facing two key issues, deprecating rupee against dollar and rising inflation. Both the factors are expected to have a negative impact on the economy. The recently announced policy statement aims at overcoming the twin problems with the least disruption in economic activities. However, the point to be remembered that the interest rate movement in Pakistan will be more or less similar to the interest rate movement in the USA.

According to a report from AKD Securities, "Pakistan has been maintaining a crawling peg with the US dollar since 2001 and as a consequence our monetary policy has to roughly mirror policy in the US. Recently, the Fed has started tightening its monetary policy and has raised interest rates by 25 basis points. Consequently, the Monetary Statement of SBP has indicated that it will maintain a differential with international rates, primarily US T-Bill rates.

Over the last few months, the rupee has started to depreciate against the US dollar. The decline has been due to deterioration in Balance of Payment (BoP), mainly caused by a worsening of the trade balance. Increase in imports of machinery, rise in oil prices and the end of Saudi Oil Facility increased the demand for dollar. The BoP position was also adversely affected by the increase in services account deficit and capital account deficit. Remittances also recorded a decline.

In the monetary policy statement issued for the first half of 2004-05, the State Bank of Pakistan (SBP) has indicated at a "measured tightening of monetary policy" to ensure that the current growth and investment momentum is maintained and inflation is controlled. The central bank expects that consumer inflation is likely to behave normally in the current fiscal year in contrast to the rapid increase in inflation in the last year where inflation settled at 4.57% thereby crossing the revised target of 3.8-4.2% set for 2003-04.

Given the substantial monetary expansion during the last fiscal year amounting to 17.6%, as compared to the target of 11.1%, the SBP intends to pursue a measured tightening of the monetary policy with the monetary expansion targeted at 11.4%. It is believed that the tremendous growth in the Net Domestic Assets (NDA) of the banking system of 225% in 2003-04 over the target of Rs 100 billion has been taken into account by the SBP, evident from the NDA targets set for 2004-05. The NDA target for 2004-05 has been set at R 250 billion, versus the actual figure of Rs 325 billion for 2003-04, on the back of an expected increase in private sector credit to Rs 200 billion. Moreover, the SBP expects that consumer inflation is likely to behave normally, and to remain within the target of 5% set for 2004-05.

The central bank has also highlighted a few threats for the current fiscal year, particularly, the need to match foreign interest rate hikes, an increase in asset prices and worsening of the trade balance. On the brighter side, it expects the fiscal deficit to remain at 4% of GDP, a lowering of inflationary pressure from capital inflows and a reduction in cotton prices during the coming year. Additionally, the SBP foresees decreased pressure on private sector credit due to reduced capital expenditure, particularly by the textile sector. Moreover, the SBP has again indicated that it does not intend to pursue an aggressive tightening of the monetary policy to prevent stifling of economic growth. The SBP has also asserted that the rise in rates will be gradual to prevent stifling of economic growth. Overall, the main intent of the policy is to ensure adequate availability of bank credit to the private sector while keeping inflation in check.




The SBP has correctly pointed out that changes in various macro factors have considerably altered the economy's risk scenario since the release of the last policy statement. Key negative changes highlighted by the SBP are: 1) Hikes in international interest rates will have to be followed by an increase in local rates to ensure that the gap between the two does not widen too much. 2) Continued strong demand for imports is likely to further deteriorate the trade balance during the current year. 3) Private sector credit is anticipated to grow at a fast pace in 2004-05 as well, albeit at a slower pace than that in 2003-04 and 4) Adjustments in wages and a rise in asset prices are likely to exert further pressure on inflation.

On the brighter side, the SBP foresees the following positive developments: 1) Fiscal deficit is likely to remain at 4% of GDP along with an improvement in financial balances of public sector enterprises. 2) Lower capital inflows are expected to reduce monetary growth. 3) Cotton prices are likely to witness a fall in the current year. 4) A decline in capital expenditure, particularly in the textile sector, should relieve some pressure on private sector credit growth and 5) Import of wheat should help stabilize prices of wheat flour.


In light of the abovementioned factors, the SBP feels the biggest threats are posed by rising prices and a change in the value of the rupee. These factors are a consequence of the monetary expansion witnessed in the last two years. Having said that, the central bank has also made it amply clear that it feels that an aggressive shift in policy could slowdown the growth and investment momentum in the economy. Moreover, it also emphasizes the fact that the labor market suffers from a high degree of unemployment and a rapid shift in stance is likely to worsen this situation.


The National Credit Consultative Council has also released the Credit Plan for 2004-05. The plan targets monetary expansion of 11.6% or Rs 280 bilion. The growth is based on Net Foreign Asset growth of Rs 30 billion and Net Domestic Asset growth of Rs 250 billion. The main driver of growth is anticipated to be private sector credit, which is predicted to reach Rs 200 billion. The government intends to borrow Rs 50 billion, while the Agriculture Credit Advisory Committee has suggested a target of Rs 85 billion for the agri sector.


Similar to the case for 2003-04, the main source of growth in money supply is anticipated to be private sector credit during the current fiscal year. The SBP expects it to stand at Rs 200 billion in 2004-05 as opposed to Rs 300 billion for the previous year. The lower growth target for the current financial year is a natural consequence of increasing interest rates and the fact that the initial growth spurt in consumer financing has passed. Moreover, the industrial sector took considerable advantage of low interest rates and borrowed heavily during 2003-04. The current year is unlikely to witness the same level of the manufacturing sector.


The government intends to borrow Rs 45 billion for budgetary support and another Rs 5 billion for commodity operations during the on going financial year. Given that the government's bank borrowing recently at over Rs 60 billion against a target of Rs 10.6 billion, the abovementioned value should not be taken at face value. Additionally, the government aims to borrow Rs 84.8 billion through auctions of Pakistan Investment Bonds, Rs 74.8 billion from the banking sector and Rs 10 billion from the non-banking sector.


The Agriculture Credit Advisory Committee has suggested a target of Rs 85 billion for 2004-05. This translates into a 30% growth over last year's target and 16% rise over actual disbursement during 2003-04. Increased emphasis by the government on the agricultural sector, reduced interest rates for farmers and the introduction of new agri products by banks should help in achieving, if not exceeding, this target. While the Zarai Taraqqiati Bank continues to be the single largest lender to the farming sector, all major commercial banks have significantly increased their participation in the agri sector. This is likely to go a long way in increasing the disbursement of agriculture credit.


The SBP has been gradually tightening the monetary policy for some time. A slow, but steady rise in interest rates has thus already been priced in the market. Consequently, analysts do not expect this policy statement to have any significant impact on the stock market because the market is focusing on growth rather than dividend yield. Besides, the SBP conscious of maintaining the growth momentum, interest rates are not expected to increase significantly.

Some of the brokerage houses have carried out detailed analysis of impact of hike interest, both long-term and short-term rates, on the KSE-100 Index. One of the studies shows that the relation between 6-month rates and the KSE-100 is highly negative. However, it is relevant to point out that this was primarily due to the impact of lower financial costs leading to earnings growth over the last few quarters. The story going forward is likely to be focused on top line growth that is likely to be unhampered if the interest rate increase is limited to 100-175bps from current levels.


According to some analysts, monetary expansion in 2004-05 is likely to exceed the target set by the credit plan. There are three reasons for this assertion: 1) While private sector credit should be less than that witnessed during 2003-04, the introduction of new products by banks could further invigorate interest in consumer financing. Moreover, a rise in the import cost of raw material goods due to higher production capacity is likely to compensate for the decrease in capital expenditure by manufacturers. The combination of these factors could result in surpassing the private sector credit target. 2) The target set for government borrowing is likely to be surpassed during 2004-05 as well. 3) The greater emphasis on the agri sector by both the government and the commercial banks is likely to result in greater disbursement to the sector than is envisaged by the plan.

Vigilance by the SBP to keep the exchange rate and inflation stable will be positive for the economy. The policy statement elucidates SBP stance that it will not allow the interest rates to increase rapidly as it may adversely impact the growth momentum of the economy. The growth in 2004-05 is likely to reply significantly on external demand driving the textile exports, and a gradually weakening exchange rate will help export competitiveness. Any measured increase in the interest rates is unlikely to have any significant negative impact on the economic growth prospects.