May 26 - June 01, 2008

The Central Bank has once again increased the discount rate by 1.5 percent making the key discount rate from 1.5 percent to 12 percent in one go with a single point agenda to contain what it is called the ever increasing inflation which is officially conceded at 17.2 percent.

Academically, the central bank moved in a right direction but practically speaking it never produced the desired results in respect of controlling the unbridled inflationary pressures but on the contrary it has consequently has its fall out on the economic growth of the country which is estimated to be somewhere around 5 percent at the end of the fiscal year next month.

It is a known fact that the inflationary pressures in Pakistan were oil and food price driven and one hardly finds any relationship between oil driven inflationary pressures and the tool of tightened monetary policy. Considering the tightened monetary policy as the only yardstick to control rising inflation seems quite ineffective and calls for a second thought especially in view of increasing infected portfolio of the banks which has risen from Rs1.90 billion to over Rs 17 billion in the first quarter and it is feared that the size of the bad loans may further go up in the face of increasing interest rates.

Actually, if capital market is taken as benchmark and an effective indictor of the state of economy, it was loudly mad clear through a massive drop of around 1000 points in KSE-100 Index just in two days on May 22-23 demonstrating a total disliking to the increase in discount rate by the State Bank of Pakistan.

Commenting on the moves initiated by the State Bank the leading business houses of the country including Chairman APTMA and the President of FPCCI both have expressed gloomy views on the increase of discount rates with the remarks that it would lead towards stagnation of the economy due to tremendous increase in the cost of doing business in Pakistan. They feel that slowing down of the economy would consequently add fuel to fire in the form of unemployment and the end result would increase poverty level.

Dr. Salman Shah, former Advisor to PM on financial affairs while referring to fast eroding economic gains like foreign exchange reserves being washed away from $16 to $11 in short span of time, growing current account and trade deficit attributed the erosion in the economic fundamentals to the uncertain political conditions persisting for quite sometimes in the country.


Iqbal Ebrahim, Chairman, All Pakistan Textile Mills Association (APTMA) has shown serious concern on the announcement of the decision of the Governor State Bank of Pakistan to increase discount rate by 1.5% and levy of 35% Margin requirement on opening of L/C would lead to closure of Industrial Sector specially the export oriented industries.

Commending on the decision of increasing discount rate, Chairman APTMA said that increasing of discount rate by 1.5% and imposition of 35% margin requirement on opening of L/C will put negative impact on over all economy. He was of the view that from now on no L/C will be opened because the industry has to pay mark-up on the margin which will also increase the cost of production. He said that we were asking for relief in high interest rate for the textile industry on the other hand we are shocked by the increase in interest rate.

Iqbal Ebrahim further said that the manufacturing sector is already facing cash flow problem due to high cost of all inputs in addition to several other problems such as shortage of electricity and gas, raw material crisis, inflation and high cost of doing business, now the requirement of 35% Margin on import will result in severe liquidity crunch which will increase the probability of default in payment of their liabilities. Rise in discount rate will increase the burden on the industry as this will have direct relation with increase in cost of raw material.

Iqbal Ebrahim was of the view that the textile industry which is export oriented industry should be exempted from the requirement of L/C Margin because the cost push factor has already made our industry uncompetitive. He suggested that all industrial raw materials like cotton, machines, machine spares, dyes and chemicals etc. should be exempted from this requirement as these are required to earn valued foreign exchange after value addition.

Chairman APTMA emphasized that the textile industry is not the cause of inflation in the country in fact textile sector is the largest employer in the manufacturing sector and earns much needed foreign exchange for the country. He said that the question is why the government wants to kill the goose that lays the golden egg.


The last Monetary Policy Statement (issued on January 31st, 2008) tightened monetary policy keeping in perspective the trends and developments surfacing in the first two quarters of FY08. SBP had also enunciated clearly in the MPS the growing domestic vulnerabilities and risks facing Pakistan's economy given the disruptions in 2007 both on economic and political front. Renewed pressures are visible in the country as the domestic and international economic environment and outlook has changed significantly. Multidimensional global developments including the growing liquidity crunch and the rising global commodities prices as well as the rising domestic twin deficits reflect the significant aggregate demand. Together these developments are now manifesting themselves into heightened inflationary pressures which unless curbed is expected to magnify further.

The unfolding events on both international and domestic front have enhanced the economic stress worldwide as well as in Pakistan. Most countries, developed or developing, are likely to register a slowdown, and have witnessed exceptional rise in inflation, which is now emerging as the biggest challenge facing the global economy. Central banks are and will be expected to play a key role in the current global scenario to strike a balance between growth and price stability. On the balance it is being acknowledged across all economies that managing domestic demand pressures is critical in avoiding further and steeper rise of inflation; current rate of inflation has already started to impact economic growth and has induced fresh threats to economic stability.

Pakistan's macroeconomic outcome for FY08 has deviated considerably from the original projections. This has necessitated re-examination of the monetary policy framework that was based on different assumptions related to fiscal and external current account deficit as well as output growth and inflation. The slippages in twin deficits and borrowings of the government from the SBP have grown persistently every month. Equally concerning is steady rise, but now a sharp spike in year-on year indicator of food inflation. These trends have reached a proportion that are now unsustainable and without corrective actions carry risk of creating more macroeconomic complications.

Few developments stand out and reflect the unprecedented economy wide pressures and highlight the urgency of an immediate monetary policy tightening.

First, external current account deficit has increased at a pace that is difficult to sustain given the slowdown in financial inflows. The rising external current account deficit owing to widening trade deficit indicates that, despite a decent export performance, significant import demand pressures exist in the economy. Underlying this alarming trend, most worrisome is the acceleration in import demand during the first four months of 2008 that has been rising unabated over the entire fiscal year. During this period, import bill has increased by US$13.4 billion while export revenues grew by only US$6.9 billion resulting in an increment of US$6.5 billion in trade deficit. Most distinct is the extraordinary growth in the non-oil and non-food imports running at 42 percent during the same period. Consequently, the external current account deficit is projected to range between 7.3 7.8 percent of GDP, which is much higher than the initial projection of 5 percent for FY08. This is clearly unsustainable and calls for taking urgent corrective actions.

Second, original projections of balance of payments were casted assuming growth in foreign exchange inflows in line with the results of FY07. However, liquidity constraints in global financial markets and the domestic political uncertainty have impacted the net foreign inflows position. Burgeoning external current account deficit along with slowdown in foreign direct investment and foreign portfolio outflows has resulted in drawdown of reserves by US$3.7 billion over July 1- May 16 FY08 and by US$4.6 billion relative to end-October 2007.

Third, complications on financing of external current account deficit coupled with speculative positions in the domestic foreign exchange market have put enormous pressure on the exchange rate. Since end-June 2007, the Pak Rupee has depreciated by 14.9 percent up to May 21, 2008 and most of this depreciation is concentrated in the last six weeks or so. Up to end March 2008, the Rupee depreciated by only 3.9 percent and since then it has depreciated by 10.8 percent. The effects of this depreciation on domestic inflation will emerge in the coming months. Recognizing the prevailing pressures on exchange rate, SBP is committed to maintaining macroeconomic stability which should help further stabilize exchange markets. The monetary tightening along with the structural changes to limit central bank borrowings for budget should help infuse exchange rate stability. In tandem, SBP has launched structural reforms of exchange companies which are intended to incentivize them to augment inflows, while maintaining strict discipline and proper disclosure.

Fourth, given substantial slippages, budget deficit is projected to be significantly higher relative to the original budgetary estimates for FY08. By December 2007 (latest available data), it had reached Rs356 billion against the full year budgeted estimate of Rs399 billion and since has exceeded the budgeted target by a wide margin. The aggregate demand pressure from fiscal module compounded as the government opted to rely excessively from central bank borrowings which, being inflationary, have fuelled considerable inflationary pressures. Rather than retiring its borrowings from central bank, as mutually agreed at the beginning of FY08, government's borrowing during July 1- May19, 2008 reached Rs544.1 billion. Stock of outstanding Market Related Treasury Bills (MRTBs), an instrument through which government borrows from SBP on tap for replenishment, has reached Rs945.9 billion (almost 9.4 percent of GDP); highest ever in Pakistan's history and more than double of last year's level of Rs452.1 billion. The borrowings from the SBP are leading to enormous expansion in reserve money and overall money supply in addition to seriously complicating monetary policy management. This trend has reversed the decline in core inflation which had come down to 5.2 percent by May 2007 -- a success achieved as a result of few rounds of monetary tightening over the preceding 18 months.

Fifth, despite monetary tightening in January private sector credit has grown consistently and has outpaced last year's growth. Credit to manufacturing, particularly textile sector that benefited from additional incentives, has been steady. One plausible explanation for strong private sector credit growth is the fall in real lending rates. As a result of persistent increase in domestic inflation, real interest rates have fallen from 3.4 percent in December to a meager 1.9 percent in March 2008. Real lending rates in Pakistan has been low now for quite some time. To suppress the aggregate demand pressures and rising inflationary trends, it is imperative for real lending rates to increase.

Finally, combination of these developments has raised the headline inflation to an alarming level. On year on year (YoY) basis, it has almost doubled in just four months; moving from 8.8 percent in December 2007 to 17.2 percent in April 2008. More disturbing is the trend of food inflation, which has also doubled spiking to 25.5 percent from 12.2 percent during the same period. Although the importance of administrative supply side measures cannot be undermined in taming food inflation, the urgent need for further tightening to address their second round impact on headline inflation cannot be ignored either. Core inflation measures, depicting persistent and mounting demand pressures, also portray worrying trends. Non-food non-energy measure of core inflation has jumped from 7.2 percent in December 2007 to 10.8 percent in April 2008. Similarly, 20 percent trimmed measure of core inflation has peaked to 14.1 percent. These trends have undermined the past few years of monetary tightening which had significantly curbed by mid 2007. With oil price in the international market now hovering around US$130 per barrel, there is likely to be additional consequences for macroeconomic imbalances and inflation.

Significant slippages in domestic and external deficit for FY08 and the complications of its financing mix and requirements, particularly borrowings from the SBP, have reached unsustainable levels. Based on current macroeconomic trends, the average headline inflation for the entire FY08 is forecasted to be over 11 percent -- almost double the target of 6.5 percent. To manage and cool-off inflation expectations and to tame the underlying dynamics, SBP has decided to introduce following policy actions:

(i) Increase in the SBP policy discount rate by 150 bps to 12.0 percent w.e.f. May 23, 2008. This increase has been necessitated by the persistent and excessive government borrowing from SBP to meet the financing requirement of the budget deficit. Stock of government borrowing from SBP is more than double of last year's level. In order to offload this huge debt to the scheduled banks, this increase will act as a critical measure to induce scheduled banks to participate actively in T-bill auctions, which have been mostly unsuccessful in mobilizing receipts for the government in recent past. This will also help in pushing up the low and decline real lending rates necessary to curb the demand pressures and decelerate the current rapid rise in inflation. An increase in interest rates is necessary to encourage savings in the economy, importance of which cannot be over emphasized given the state of fiscal and external current account deficits. The increase in the policy rate will also calm down the sentiments in the domestic foreign exchange markets and make it attractive to lure more foreign inflows. It will also curb the second round impact of food inflation and oil price increase to headline CPI inflation going forward.

(ii) Increase in the Cash Reserve Requirement (CRR) for all deposits up to one year maturity by 100 bps to 9.0 percent while keeping the CRR for deposits of over one year maturity unchanged at zero percent. In addition, the Statutory Liquidity Requirement (SLR) is increased by 100 bps to 19 percent of the total time and demand liabilities. The increase in the CRR is supposed to have an immediate impact on interbank interest rates by drying up excess liquidity; this can be ensured at present only with a concomitant rise in the SLR since the banks are already keeping government papers over and above the current requirement of 18 percent. In case, the CRR is increased in isolation, banks are likely to liquidate their investments to make up the liquidity shortages due to CRR increase, thereby diluting the impact of policy measures. The net impact of the rise in both the CRR and the SLR would then be translated into an increase in market interest rates. An additional positive impact of this measure is likely to be on deposit mobilization as the banks would be forced to generate more deposits to cope with liquidity requirements for their operations.

(iii) Effective 1 June 2008, all Banks are required to pay a minimum profit rate of 5 percent of Saving/PLS saving products. The saving deposits category account for more than 43 percent of all bank deposits and constitute 63 percent of the total number of countrywide deposit accounts. While on the margin deposits rates have risen, given the stock of deposits on which returns remain low the average return on all saving accounts is at 2.1 percent. The inelasticity of the deposit rates to the monetary policy signals of SBP makes the transmission of the monetary stance less effective. Impact of any increase in the discount rate by SBP is immediately transmitted through advances; however, there is little impact on the deposit rates and hence, there is no incentive for the currency in circulation to move into bank deposits. SBP has been relying on moral suasion and competition among banks to encourage rise in returns on deposits. While this has facilitated greater awareness in banks and differential and higher returns by smaller banks, but by and large increment on deposit rates has happened principally for large deposit holders. In 2008, given the low returns, the growth of deposits has been impacted thereby affecting the capacity of the system to service growing economy wide requirements. This measure is also necessitated by the slower growth in overall deposits. The rise in deposit rate will help bring in high level of currency in circulation into the financial intermediation process and allow banks to have higher level of resources to serve the credit requirements of the economy.

(iv) Effective 23 May, the L/C margins on all imports except for oil and selective food imports is being imposed at 35 percent.

(v) The Government is well advised to sterilize the expected foreign inflows by using the foreign resources to settle its obligations to SBP. Rather than use fresh foreign inflows to finance new expenditures, retirements of MRTBs will help reduce the reserve money pressures.

(vi) The Government is being further advised to amend the Fiscal Responsibility and Debt Limitation Act, 2005 to incorporate appropriate provisions to restrict the debt monetization. Most countries have disallowed government to borrow from central banks to allow smooth monetary transmission, while averting the inflationary consequence of debt monetization. Currently, the Government has kept borrowings from the central bank outside this legislation which has eroded the fiscal discipline and diluted the impact of the Fiscal Responsibility Act. In FY08, it is estimated that up till now the Government will have financed around 80 percent of its fiscal deficit from SBP borrowings. Excessive borrowings from the central bank has also resulted in rise in floating debt (that comprise of short-term instruments such as T-bills), raising its share in GDP from 11.1 percent at end-June 2007 to 14.7 percent by end-April 2008. On margin this heavy reliance on debt monetization helps the government reduce its financial cost. However, real economic costs of central bank borrowings cause enormous inflationary pressures, whose burden falls on businesses, industry and public at large. So the government is best advised to launch a program of scaling the SBP borrowing by reducing its stock of borrowing from the central bank over next few years, while not relying anymore on central bank financing. This will infuse greater fiscal discipline as the real hard constraints are imposed on the budget.

These tightening measures along with the government's consolidated fiscal program for the medium-term would bring the desired macroeconomic stability enabling the country to escape a structural downward shift and brightening the long term growth prospects. Moreover, this would enhance exchange rate stability for which the SBP has already taken several measures during the last three weeks including:

* Exchange companies have been directed to transfer foreign currency from their Nostro accounts held outside Pakistan to commercial banks in Pakistan and henceforth exchange companies will have to close all Nostro accounts abroad.

* Exchange companies have been encouraged to focus on promoting home remittances and companies can only affect outward remittances to the extent of 75% of the home remittances mobilized by the respective company.

* In order to meet the demand of foreign currencies within Pakistan, the Exchange Companies have been directed to surrender their surplus foreign currency to State Bank earlier exchange companies were exporting most of the foreign currency, except dollars abroad. Now exchange companies, besides dollar, will not be able to export Pound Sterling, Euro and UAE Durham's.

* Exchange companies have been required to surrender a minimum of 15%, instead of earlier 10%, of foreign currencies received by them from home remittances to the interbank markets.

* Limits on advance payments that were relaxed last year have been tightened. Now advance import payments will only be allowed against letter of credits and that too only to the extent of 50%. Advance payments against contracts are now not allowed. Last year advance payments against letter of credit and firm registered contracts were allowed to importers via banks to the extent of 100%.

* Some reforms of the forward hedging mechanism available to importers / exporters have been introduced to ensure that there is no misuse of the facility other than true hedging.

* State Bank of Pakistan has increased the frequency of "surprise inspections" on banks and exchange companies in relation to their compliance of all foreign exchange related regulations.


The total liquid foreign reserves held by the country stood at $ 11,885.2 million on 17th May, 2008. The break-up of the foreign reserves position is as under: -

i) Foreign reserves held by the State Bank of Pakistan:

$ 09,500.1 million.

ii) Net foreign reserves held by banks (other than SBP):

$ 2,385.1 million

iii) Total liquid foreign reserves:

$ 11,885.2 million