Burgeoning external imbalances continue posing new challenges
SHABBIR H. KAZMI, Special Correspondent
Jan 29 - Feb 04, 2007
The State Bank of Pakistan had announced its Monetary Policy Statement in July last year. Over the months a lot has been written and talked about the outcome of policy measures. Just to recap it is sufficient to say that at the end of first six months of current financial year the challenges facing the economy remain almost the same. Despite the best efforts of the central bank the inflation is likely to remain above target. The situation demands initiating appropriate administrative measures to contain food related inflation in particular. On top of this international prices of commodities continue to exert pressure and keep inflation high in Pakistan. Expansionary fiscal stance coupled with upsurges in borrowings from SBP and financing mix of the deficit makes implementation of the policy a bit difficult. Adding to this is burgeoning external imbalances that continue to pose serious challenge to Pakistan's economy.
In Pakistan's context it is necessary to understand the key reason of higher inflation i.e. the hike in cost of doing business. This is eroding competitiveness of Pakistan's exports. It is on record that trade deficit has touched new highs due to an unexpected slowdown in export growth. While imports have grown around 10% export growth could not be achieved beyond half of this rate during the first half of current fiscal year. The deceleration in exports confirms severe global and regional competition but the country continues to suffer from some structural weaknesses.
To achieve its policy objectives, SBP has been resorting to frequent open market operations (OMOs) to drain excess liquidity from the inter-bank market. The proactive liquidity management is helping in containing overnight borrowing rates and brining these close to discount rate as well as reducing volatility of short-term interest rates. To ensure availability of credit for industrial sector the central bank also allows liberal access to concessional long-term financing for export oriented entities and keep the interest cost of eligible items low under the export refinance scheme. This policy is been followed to neutralize the adverse impact of monetary tightening on investment and export growth. The concessional financing by the central bank has contributed significantly to growth of reserve money during July-December 2006.
One of the factors contributing to inflation is money supply (M2). Tightening of monetary policy is reflected by slight deceleration in M2 growth during July-December 2006 to 7.6% compared to 7.9% during the corresponding period of 2005. The M2 growth would have been even lower had the Net Foreign Assets (NFA) of the banking system not built up during this period. The NFA of the banking system expanded by Rs 11.5 billion during six month period against a substantial contraction of Rs 66.7 billion a year ago.
Having said this it is necessary to reiterate that the decline in core inflation was eclipsed by the persistently high food inflation, stemming principally from supply side disturbances. In totality, the average consumer price index (CPI) registered an increase of 8.4% during six months, which was well above the annual target of 6.5% for the full year. The inflation in Pakistan is relatively higher compared to its competitors and trading partners. In fact, this higher domestic inflation has offset the gains emanating from nominal depreciation and the real exchange rate, measured in terms of the real effective exchange rate (REER) index.
The common perception is that with the decline in POL prices in the domestic market the inflation rate would come down. However, analysts are of the view that despite the downward revision in domestic oil prices the inflation is likely to remain higher than the target because of higher food inflation. The key challenge will be to keep the inflation as close to the target as possible. Therefore, administrative measures would play a vital role but the central bank will have to adhere to its strict monetary stance to avoid further hike in inflation rate.
Many analysts talk about inflation in Pakistan without taking into account other regional economies. It is on record that during 2006 inflation in most of the countries remained high due to higher oil prices. However, the global outlook for 2007 seems encouraging particularly in the backdrop of an expected reduction in global demand and deceleration in oil prices. To contain inflation and restrict demand, majority of the central banks in the region pursued a tightening stance and raised key policy rates. Some of them maintained a status quo on interest rates. Aggressive monetary tightening by various central banks led to a rise in the lending rates of the commercial banks causing a slowdown in private sector credit off-take.
Looking ahead, it is expected that the headline inflation would slowdown because of monetary policy measures taken by the central bank. Food inflation is also likely to ease due to improving supply of key food items and favorable weather conditions for the wheat crop. SBP announced to pursue a stringent monetary policy stance during the remaining half of current financial year. It also plans to remain fully vigilant of the developments in the economy and take timely corrective actions, as and when desired.
DIFFERENT DIMENSIONS OF INFLATION (PERCENT)
YEAR-ON-YEAR (DEC OVER DEC)
PERIOD AVERAGE (JUL-DEC OVER JUL-DEC)
12-MONTH MOVING AVERAGE
MONTHLY (DEC OVER NOV )