Nov 22 - 28, 2010

In the wake of unbridled inflationary pressures as well as food inflation the possibility of further increase in the interest rate in the next monetary policy review due on Nov 29, 2010 cannot be ruled out.

Though the policy rate hike is essentially required to contain inflationary pressures yet the tightening of the monetary policy will only produce results when it is closely associated with the fiscal measures on the part of the government besides a close coordination between the government and the central bank to achieve the desired results.

It may be recalled that the central bank had raised policy rate by 50bps two months ago in September 2010 with a view of inflation and macro imbalances, which showed outright concern over economic management by the government and public sector heavy borrowing from banking system, which is roughly estimated over 50 percent. This attitude of the public sector continues to crowd out the private sector and is also responsible for inflationary pressures. While the inflation spanning out as expected the government has made some headway by tabling tax reforms in the parliament.

On the back of flood damages to the cotton crop the risk of higher cotton prices is surfacing which naturally will add to the input cost of the textile sector the major earner of the foreign exchange for the country. Hence, the inflationary pressures seem inevitable in the given circumstances such as food inflation and structural adjustments on power sector subsidy as well as tax reforms would entail inflationary costs too.

It is also feared that on one hand the increase in global commodity prices may consequently compound inflation further while fiscal deficit and its financing mix are the key things to have an impact on monetary environment. The government on its part has provided revised fiscal deficit target of 4.7 percent for financial year 2011, which apparently seems difficult to achieve.

Despite the fact that the monetary environment now rests on financing mix of the same which depends on progress on structural reforms in the energy and taxation reforms, it is feared that these steps may give a rise to political opposition.

In fact, it is a complex situation because the government naturally looks for uninterrupted flow of funds from donor agencies, which have linked the financial support to the structural reforms in the energy sector as well as in the taxation regime. It is indeed a difficult situation as the failure to expedite structural reforms consequently results in delays in external flows. In this backdrop, further monetary tightening is quite possible.

Meanwhile, the exchange rate during financial year 2010 continued to reflect market conditions which helped narrow the external imbalance and improve macroeconomic stability.

Foreign exchange reserves which were at $12.425 billion at the close of financial year 2009 increased by $4.325 billion to reach an all time high of $16.750 billion at the close financial year 2010.

Because of reforms introduced in the banking sector of the country, it helped the financial sector to withstand headwinds from weakening macroeconomic fundamentals since 2007. Although banks face increased credit risk, the overall sector is well placed to withstand modest shocks as they build their inventory of government securities.

Under the depressed economic situation and emerging dynamics in the macro financial environment the central bank has rationalised the minimum capital requirement for the banks and its implementation schedule which hopefully provides breathing space to the banking sector in this difficult macroeconomic environment.

SBP governor while reviewing the performance of the financial sector and the given circumstances especially the challenge of containing inflation has explained that in response to a changing inflation outlook the state bank of Pakistan adjusted its stance on monetary policy. The decline in inflation during initial months of financial year 2010 and a relative improvement in the macroeconomic situation allowed the central bank to ease its monetary policy stance. However, the growing fiscal deficit and unexpectedly low external receipts increased risks of a relapse into macroeconomic instability and as inflationary pressures resurfaced in the second half of financial year 2010 the central bank decided to pause the easing cycle and subsequently increased its policy rate in July and September. He however did not say anything about future course of interest rate though, according to him, the foreign exchange reserves are at a record level.

In order to have a quick review of the monetary environment the central banks also increased the frequency of its monetary policy statements from four to six times a year. With a view to improving communication with the market, the monetary policy framework itself experienced significant change when the SBP introduced an interest rate corridor in August 2009. This framework anchored short-term interest rates and improved liquidity management in the money market.


Standard & Poor's Ratings Services affirmed its 'B-' long-term and 'C' short-term sovereign credit rating on the Islamic Republic of Pakistan. The outlook on the long-term rating is stable.

Standard & Poor's also affirmed its 'B-' issue rating on Pakistan's senior unsecured local-currency debt and the transfer and convertibility (T&C) rating of 'B-'.

Likewise, we affirmed the 'B-' issue rating on the sovereign's senior unsecured foreign-currency debt, as well as its recovery rating of 3, which denotes our expectation of a meaningful recovery of 60 percent-70 percent in the event of a distressed debt exchange or payment default.

"The ratings affirmation takes into account Pakistan's improved external liquidity position, which was largely due to the International Monetary Fund (IMF) standby loan agreement and other bilateral and multilateral support," said Standard & Poor's credit analyst Agost Benard.

"This credit strength is weighed against the sovereign's high public and external leverage, political and security risks, and fiscal inflexibility due to an exceedingly narrow tax base," he said.

We could lower the ratings if major slippages in policy occur, resulting in renewed balance of payments difficulties or rising public debt trajectory. Conversely, we could raise the ratings if Pakistan is able to sustain its macroeconomic stabilisation program and fiscal consolidation efforts—indicated by moderating fiscal deficit and a steady reduction in public debt.