MONETARY POLICY STATEMENT
Tightened stance to continue but with lesser magnitude
By SHABBIR H. KAZMI
July 25 - 31, 2005
The Government of Pakistan has, so far, released three important policy documents, namely: Budget, Trade Policy and Monetary Policy Statement. The next item on the agenda is Textile Policy, to be announced in August. All these documents give clear indication of the government's strategy to steer the economy during the current fiscal year. A message is common in all these policy documents that the government wants to accelerate the GDP growth rate to improve the quality of life of people. While some of the internal and external factors, impacting the economy, are not in the control of the government, there is also a commitment to minimize the adverse impact.
In the budget the government had announced various fiscal measures to facilitate growth of agriculture, manufacturing and services. However, it is evident that the performance and growth of these sectors was directly linked with the interest rate movement. Since January this year the government has been following a rather neutral monetary policy and the latest announcement is also an extension of this policy. The government faces a serious challenge of balancing short-term and long-term interest rates. Any attempt to raise short-term interest rates is bound to push the long-term interest rates. The government has been trying to create the balance, which some times creates some distortions. However, timely injection of liquidity and OMP operations help in keeping the interest rates movements within the desired range.
Some analysts are of the view that interest rate is not an appropriate tool to control rate of inflation in Pakistan. They say, "Pakistan mainly suffers from cost pushed inflation, where external factors play a vital role. The biggest culprit is POL prices. It goes without saying that any rise in the prices of POL products virtually pushes up the prices of every item. Energy prices are already high due to very high rate of taxes applicable on these products. However, the various governments have been collecting higher taxes on these products, due to inability to increase collection of direct taxes.
Another factor contributing to higher inflation is food prices. It may be true that at times the country gets lower production of these items, but the real problem is smuggling of these items to the neighboring countries. At least three items, i.e. wheat, edible oil and sugar, are moving out of the country freely. It may be true that Pakistan also gets some other items in return, but unchecked outflow often creates serious supply issue.
Pakistan is very lucky as it has sufficient foreign exchange reserves at least for the time being. The point of concern is that the country has not been able to further build up these reserves, in fact the quantum is depleting with the passage of time. On top of this is the growing trade deficit which is putting pressure on these reserves. Trade deficit for the last financial year was above six billion dollars. The government has fixed the trade deficit target of 4.5 billion dollars for the current fiscal year. However, analysts fear that the full year deficit would be higher because of higher import bill of crude and POL products. Import of wheat, sugar, fertilizer and cement is also expected to push up total imports. They say, growing trade deficit and depleting foreign exchange reserves can enhance exchange rate volatility, which has the potential to push up interest rates.
Though, there is a fear of further hike in the interest rates, some of the analysts say that interest rates have already touched the peak and further increase would only be marginal. Their point of view is based on the fact that with the improvement in corporate earnings, demand for credit by the private sector would not exceed the supply. The government borrowing has increased but it is being met by the central bank. It is expected that this year inflow of assistance and grants may also improve, easing the liquidity.
There was an expectation that the government would enhance the rate of return on the National Savings Schemes. However, the latest increase is below market expectations. Therefore, one may not see massive movement of funds from bank deposits to NSS. However, there could be some flow from equities market to NSS. It is not because the return will be higher but because of persisting uncertainties in the equities market. Margin financing is an issue but the bigger concern is ongoing rift between the Securities and Exchange Commission of Pakistan and the Karachi Stock Exchange.
Equities market has not started utilizing the margin financing option as yet. However, some analysts are of the view that equities market needs injection of about 50 billion rupees. There are efforts to divert funds towards equities market but it could become reality only once investors' confidence is restored in the market.
The NSS rate increase is important for the retail investors and they may divert part of their investment from equities market. However, the rise does not offer any opportunity to institutional investors due to certain restrictions. Some analysts are of the view that there may not be any outflow from the equities market because capital gains are still tax exempt but profit from NSS is taxable.
As against this, some analysts say that the total investment in NSS is approximately 700 billion rupees, which is roughly 30 percent of the total bank deposits maintained with the commercial banks. Stock market capitalization is estimated a little above two trillion rupees and bonds market size is about 638 billion rupees. Therefore, any movement of funds from capital markets into NSS or bank deposits could have profound implications.