MONETARY POLICY

TIGHT MONETARY POLICY CARRIES THE SIDE-EFFECTS AS WELL

AMANULLAH BASHAR
Aug 04 - 10, 2008

The central bank has raised the Discount Rate (DR) by 100bp to 13.0%, which was the third in a row since 31 January 2008 .

It is pleaded that the rate hike is in line with the consensus estimate and essential to arrest the twin malice of inflation and fiscal deficit. But there is something more also, as reacting to the government's excessive borrowing from the banking sector, the commercial banks had refused to lend to the government unless the DR was increased to make the deal commercially viable and attractive for the lenders.

Tightening of monetary policy is, of course, an effective tool to contain inflationary pressures but it carries some side effects on economic activity especially the higher interest rates have a strong fall out on the goods and supplies which is also an effective area for arresting the inflationary pressures. Another visible side effect of the growing interest rates was visible in the growing size of the non-performing loans of the banking sector. Though the governor State Bank while outlining the Monetary Policy conceded that it has an impact on NPL yet she said the impact was too little while all the banks have fully provisioned the infected portfolios.

MONETARY POLICY

Dr Shamshad Akhtar, Governor State Bank of Pakistan announcing the policy statement said that considering the risk related to rising external current account and fiscal deficits and worsening inflation outlook, the central bank has decided to raise its policy rate by 100 basis points to 13 percent effective July 30, 2008 to contain further aggregate demand pressures which are contributing to the inflationary pressures.

GOVERNMENT BORROWING

Fiscal coordination with the monetary policy stance in particular commitment to scale down Government borrowings from the central bank and to contain import growth is critical to achieve the desired impact of monetary tightening. Considering the adverse impact of continued borrowing by the Government from SBP on inflation, the SBP Central Board of Directors resolved that the Government should retire Rs 21 billion in each quarter of FY09.

In order to restore macroeconomic stability there was a need for additional corrective policy actions, both at the Government and central bank level. She said assuming the domestic demand continues to grow at last five-year average of 8.1 percent and the real GDP growth target of 5.5 percent for FY09 is achieved, the difference between domestic demand and supply is expected to widen further. Therefore, it was of utmost importance to curtail aggregate demand pressures through restraining expenditures in the short run; increase the production capacity of the economy by addressing structural constraints; and improving factor productivity.

OUTLOOK

The current 2008-09 fiscal year (FY09), ought to be a year of consolidation as the new democratic Government has entered FY09 with heavy overhang in the economy of the last year's macroeconomic imbalances. At the same time, the Government carries the responsibility of fulfilling the aspirations and promises to the nation, she added.

"The trade offs are not easy and global economic environment continues to be fraught with uncertainties though some trends are quite clear: global growth has slowed down, international liquidity squeeze remains and Pakistan sovereign rating prevents tapping international markets, and uptrend in international commodity prices continues, in particular in oil," she added.

Government's heavy reliance on SBP borrowings has continued unabated with additional new borrowing of Rs149.8 billion during May 25 to June 30, 2008. Budget for fiscal year 2008/09 estimates put it at 7 percent of GDP, while financing data available to SBP for the full FY08 shows this could be around 8.3 percent of GDP. Within two months of May and June 2008, trade and external current account deficits as percent of GDP widened further by 1.5 percentage points each and exchange rate remained under pressure. In the same period, CPI inflation (YoY), on the back of high International commodity prices and high inflationary borrowing, intensified by 4.3 percentage points. Above all, second-round impact of high food inflation has become embedded in the inflation expectations.

The Government and the central bank have taken pre-emptive policy actions together. Budget for FY09 has been rolled back to 4.7 percent of GDP and Government's committed itself to achieve net zero borrowing during the course of the year, while enhancing its reliance on other non-bank sources. To reinforce further, on 10 June 2008 (ahead of the budget for FY09), SBP advised the Government that the Central Board of Directors recommend net retirement of Rs 84 billion for FY09 with quarterly retirement of Rs21 billion.

FALL OUT ON PRODUCTIVITY

On the domestic front, in addition to the demand pressures, a fall in the productive capacity of the economy is also contributing to rising inflation, she added.

Dr Akhtar underscored the need for a dynamic fiscal framework for FY09 that will incorporate necessary adjustments as economic developments evolve. She said early indications are that the budget deficit target for FY09 of 4.7 percent of GDP is already coming under stress. Aside from the changing oil and exchange rate scenario relative to budgetary assumptions, SBP assessment is that budget underestimates spending and overestimates revenues, she said and added containing expenditure growth at 6.5 percent, given a track record of 20.3 percent average increase during the last five years, seems difficult and the subsidy bill is likely to come under strain unless political pressures are muted. Similarly, realizing the estimated growth in tax revenue at 24 percent seems high given the average growth of only 12.8 percent during the last 5 years.

"It must be kept in view that past few years benefited from the high and fairly robust GDP growth (7.0 percent on average); while for the coming year a growth of only 5.5 percent is being anticipated," she emphasized.

Dr Akhtar stressed that these optimistic expenditure and revenue assumptions carry the risk of fiscal slippages beyond target again. Even a one percentage point increase in fiscal deficit above the target level would require additional borrowings in the order of over Rs100 billion," she added. "What is worrisome is that there are severe external and domestic constraints which make it difficult for raising the required financing on a timely basis for the projected fiscal deficit for FY09," she said and added generating the same amount domestically from sources other than the central bank would result in crowding out of credit availability to the private sector.

As is evident, during the first twenty five days of current fiscal year the government has already borrowed additional Rs32.9 billion from SBP. This pattern is not in line with SBP's recommendation to the government to retire Rs21 billion during each quarter of FY09.