Tightening at its peak; likely to taper off in the 4th quarter

Jan 22 - 28, 2007

The Monetary Policy for the second half of the financial year 2007 has maintained its tightening stance on the back of high reserve monetary growth which seems to be a concern in the face of anticipated monetary expansion in future which would consequently add to inflationary pressures.

Governor State Bank of Pakistan Dr. Shamshad Akhtar, however, looked quite determined while announcing the monetary policy last week focusing on corrective measures to curb inflationary pressures.

She, however, remarked: "A tight monetary policy would continue during the remaining second half of the financial year. The interest rates of 9.5 percent would remain unchanged."

The real GDP growth target of 7 percent would be achieved rather it may exceed to 7 percent mark at the end of the financial year.

Speaking about high spread of the banks, the SBP Governor said that some banks have started improving returns on deposits, however, there is a need to create awareness among the depositors to look into other options such as National Saving Schemes and Mutual Funds which are offering attractive deposit rates. Actually, the government had directed the banks to rationalize their spread between lending and borrowing rates.

The twin objective of the monetary policy - balancing growth on one hand and checking prices or maintaining price stability on the other hand - were given prime importance in the policy. The second objective is being taken care of by ensuring effective liquidity management as well as providing adequate and credit to priority areas with more favourable credit terms.

The financial analyst from Khadim Ali Shah Bukhari Securities foresees that the central bank is approaching the end of its 20-month long tightening cycle, as it has given a broad hint through maintaining policy rate at 9.5%. SBP has also expressed its satisfaction over deceleration in (1) core inflation to 5.5% in Dec-06 against 6.5% target, (2) monetary aggregate to 7.4% (from 7.9% last year) and (3) private sector credit growth to 11.5% in 1HFY07 (from 17.4% last year).

Given the threat of high domestic liquidity and external account deficit the analysts estimate 4.5% of GDP; SBP will maintain a tight monetary policy stance in the next few months but we do not expect further increase in short-term T-bill rates, going forward. However, persistent soft trade and credit flow data will prompt the central bank to move from "aggressive" to "neutral" stance from last quarter of the financial year 2007.


The central bank, while maintaining its tight policy stance for the remaining part of the financial year, has raised the daily Cash Reserve Requirement by 1% and 2%, respectively.

Consequently, a 200bp hike in reserve ratio will reduce domestic liquidity roughly by Rs50bn (4.2% of base money) imposing upward pressures on inter bank borrowing, deposit rates and ultimately on lending rates.

The reduction in intra-week liquidity for banks reduces the room for active liquidity management and should impact the gains emanating from intra-week liquidity management by the banks.

With the recent shuffling in daily CRR rates, while keeping policy rate intact at 9.5%, it seems that the State Bank has reached the end of its 20-month long tightening cycle.

It is worth mentioning that Reserve Money is a lead indicator of future monetary expansion, which increased sharply by 19.02% in the first half of the financial year that is a key concern for SBP. The hike in reserve ratio illustrates SBP struggle to control the liquidity inflows through export refinance scheme & long-term loan swap facility for textile sector, high capital account receipts and of course increasing government borrowing from central bank.

The analysts from KASB feel that impact of daily reserve ratio hikes would be more intensive than the previous adjustment of July 18th, 2006, as the estimates indicate a Rs50billion (or 4.2% of base money) outflow from system against Rs41.2billion in the last adjustment. Apart from tightening, the hike in CRR would benefit banking system's financial viability through narrowing gap, maturity mismatch and increase in long-term deposit rates in the long run.

As far as the banks are concerned, the deposit war should intensify somewhat as the pool of loan-able funds during the week will reduce. With the earlier 3% gap between intra-week and end of week requirements, banks did enjoy room for active management of liquidity during weekdays. The reduction of the gap to just 1% means that banks would have to set aside a larger pool at all times which might result in the loss of the returns generated on the excess liquidity over the course of the week. How that would impact different banks is a function of how aggressive the individual banks have been in utilizing the intra-week liquidity and should vary from bank to bank. The need to raise deposits would definitely increase, exerting pressure on spreads to some extent.