INTEREST RATE OUTLOOK

ANALYSTS EXPECT THE CENTRAL BANK TO FOLLOW A CAUTIOUS APPROACH

SHABBIR H.KAZMI
July 20 - 26, 2009

The State Bank of Pakistan (SBP) is scheduled to announce Monetary Policy Statement (MPS) for first quarter of the current financial year on 25th of this month. Most of the analysts forecast up to 200 basis points reduction in discount rate. However, keeping in view past trend and mounting pressure from the IMF some of the analysts does not expect more than 100 basis points reduction.

The recent data regarding inflation confirms the continuation of downward spiraling inflation going forward. Inflation for June stood at 13.13% YoY, resulting in an average annual inflation of 20.8% YoY for FY09. Although the weekly SPI numbers for July 09 show an increase of 112bps WoW, analysts consider it as a reflection of increase in the petroleum prices during early July. Thus, any major revision in inflationary trend is not expected going forward. The most positive factor on this front is the significant decline in food inflation of late, while it remained the most concerning factor previously due to the direct impact it exerts on masses.

The economic managers expect improvement in the production of major crops (3.5% growth in FY10), while international food prices are expected to maintain their lower levels, analysts expect food prices to exhibit some stability. Considering the recent distortion in oil prices the GoP is likely to formalize the price mechanism through linking international and local prices which would result in higher correlation in prices. Nevertheless, oil prices would continue to pose serious threat and fuel inflation.

Since last rate cut of 100bps in April this year, T-Bill yields and 6-month KIBOR have significantly declined by 120 and 156bps to 11.95% and 11.55% respectively. Downward revision in market rates during the recent quarter is based on expectations of a greater rate cut. However, analysts warn of short-term spike in secondary market rates in case foreign inflows fail to materialize to their fullest or get delayed further, or if the SBP restricts its stance to soften monetary policy.

With the announcement of the 4QFY09 Monetary Policy Statement, SBP had shown its defined stance to target inflation and control imbalances prevailing in the economy. As substantiated by the data, SBP has been successful in curtailing inflation during FY09. Although, in the post September 2009 scenario, inflows form IFIs and FoDP are still on the cards. Analysts expect SBP to take cautious strategy in dealing with inflation as monetary growth and strong aggregate demand are associated with the risk of higher inflation and current account deficit.

DECLINING YIELD

The central bank conducted its first Treasury Bills auction for FY10 a continuation of the trend witnessed throughout the second half of FY09 was evident. The target auction of Rs45 billion was oversubscribed by three times to Rs151.6 billion. However, the central bank chose to accept bids worth R57.2 billion, out of which predictably over 62% (Rs35.7 billion) went to the 12-month tenor as bidders attempted to lock in the available yields before the almost inevitable discount rate cut on July 25, 2009. The rest was divided almost equally between the 3-month (Rs10.2 billion) and 6-month (Rs11.3 billion) tenors.

According to BMA Capital report money market has remained liquid over the past week and the SBP is almost certain to cut the policy rate in the upcoming review. The cut off yields on the 6-month and 12-month bills have been slashed. Bids for 3-month bill were rejected in the last auction but this time the SBP chose to accept Rs10.2 billion at a cut-off of 11.42%. Renewed interest in both the long and short tenor treasury papers is indicative of the fact that banks are now looking to adopt Barbell investment strategy which involves balancing liquidity needs (shorter tenors) and locking down rates (longer tenors) in a declining interest rate environment.

Analysis of data from the last 5 years indicates that the correlation between cut off yields and the discount rate is very high at 0.9. In fact the average spread between the discount rate and the cut off yield on the 12-month bills has been just over 1.3% in FY09 compared to slightly under 0.7% during FY08. One of the reasons for this wider spread has been heavy interest from the banking sector in the wake of deteriorating asset quality, which has pushed down yields at an accelerated rate. If we one assumes that this spread will hold going forward then a cut of 100bps to 13% seems to be on the cards in July.

BMA maintains that keeping in view the ongoing negotiations with the IMF and World Bank, the last thing the SBP would want is to cut the discount rate by too much and then be forced to increase it later on during the fiscal year. Inflationary pressures though on the decline remain inherently vulnerable to international oil prices and increases in the power tariff. BMA expects inflation to average around 10-10.5% in 1HFY10.

Pak Rupee has been under considerable pressure over the last couple of weeks and analysts expect depreciation of around 8% over the next 12 months. Therefore, it is expected that the SBP will continue to err on the side of caution and make a cut of 100bps. Provided that oil prices stay at current levels and the promised external assistance comes through in 1QFY10, analysts expect the central bank to move more aggressively as regards to the discount rate while announcing the monetary policy stance in October this year.