MONETARY POLICY REVIEW
SBP KEEPS INTEREST RATE UNCHANGED AT 14PC

URGENT MEASURES ARE REQUIRED TO ADDRESS ENERGY CRISIS-SHAHID KARDAR

AMANULAH BASHAR
(feedback@pgeconomist.com)
Mar 28 - Apr 3, 20
11

Shahid Kardar, Governor State Bank of Pakistan, has strongly recommended urgent measures to address the energy crisis to increase productive activity.

These recommendations were made at the Monetary Policy Review Saturday last when the central bank decided to keep its policy rate unchanged at 14 percent.

'Given a favourable external current account position and relatively disciplined government borrowings from SBP, the immediate risks to macroeconomic stability seem to have subsided, at least for the next two months. Therefore, SBP has decided to keep the policy rate unchanged at 14 percent,' said the Monetary Policy Decision.

It, however, said that there is little room for complacency as the risks to the economy may increase if meaningful economic reforms are not initiated to address the structural weaknesses. Inflation persistence still remains high, which is largely formed by recent past levels of inflation and perceptions of economic agents about the credibility and direction of monetary and fiscal policies in controlling inflation and promoting long-term sustainable economic growth.

It further said the current stability in the financial markets provides valuable time to initiate structural reforms. Not only are urgent measures required to address the energy crisis to increase productive activity but the fiscal position also needs considerable strengthening to cope with rising debt obligations and to ease borrowing pressures on the banking system.

'Despite a recent improvement in the external current account, restrained government borrowings from SBP and stable financial markets, the focus must remain on addressing the structural fiscal weaknesses and reducing inflation to provide a sound platform for sustainable economic recovery in FY12. Although some measures have been announced to contain the fiscal deficit of FY11 and inflation has eased somewhat, more work is required to build on these initial efforts by maintaining progress on comprehensive tax reforms, transparent rationalization of subsidies, and the development of a forward-looking debt management strategy. This will require support from across the political divide and from other state and civil society institutions to ensure their smooth implementation. These measures would help check the level of government borrowings from the banking system, creating space for the private sector and lowering their borrowing costs thereby supporting the utilization and expansion of the economy's productive capacity. Initiation of these reforms has become critical since private and public sector investments are falling while total debt is rising sharply and expectations of high inflation are becoming entrenched.

The decline in year-on-year inflation from 15.5 percent in December 2010 to 12.9 percent in February 2011 can be attributed to three factors: First, a gradual dissipation of the effect of the flood on food prices; second, an incomplete pass-through of high international oil prices to the domestic market and a smaller adjustment in electricity prices than required by the projected size of the power sector subsidy; and, third, a reduction and thereafter containment of the stock of government borrowings from SBP to around Rs1290 billion (on cash basis). The future path of inflation would be contingent upon the policy stance adopted with respect to the last two factors. In addition, the impact of the recent removal of General Sales Tax (GST) exemptions could also influence the inflation outlook.

The SBP is confident that the government will adhere to the mutually agreed borrowing limits from SBP and, in recognition of the high level of inflation, will aim to lower them further. This should facilitate SBP in aligning monetary expansion with the level of productive economic activity while improving its composition in favour of Net Foreign Assets (NFA). By 12th March, 2011, the year-on-year growth in reserve money was 15.9 percent, which is slightly lower than the growth rate observed at the time of last monetary policy decision in January 2011, and share of NFA of SBP in reserve money has increased to 27.5 percent compared to 22.5 percent at the beginning of FY11. A continuation of these positive trends can potentially have a beneficial effect on inflation in the next fiscal year.

However, the rise in public debt with a considerable short-term maturity profile combined with reduced availability of bank credit for the private sector at higher interest rates has created challenges for monetary management in terms of striking a balance between containing inflation and promoting economic growth. By end-December 2010, the year-on-year growth in government's total debt was 14.8 percent, with 45 percent of the tax revenue being absorbed by interest payments. The year-on-year growth in private sector credit, on the other hand, was only 5 percent up till 12th March 2011. Without increasing the private sector's investment and hence its contribution to economic growth it would become more challenging for the economy to generate sufficient revenues to meet its debt obligations in the future, especially with the terms of trade shifting in favour of sectors with modest contribution to tax revenues.

The recently announced tax measures, estimated to raise approximately Rs53 billion in the remaining months of FY11, together with a cut in planned development expenditures and postponement of some subsidy payments may help in reducing the fiscal deficit for FY11 to some extent. Given the delayed announcement and temporary nature of some of these measures, the improvement in the fiscal position will require these efforts to be consolidated in the forthcoming budget. Thus, implementation of a credible medium term budgetary framework and renewed efforts to abide by the principles of the Fiscal Responsibility and Debt Limitation Act (2005), geared towards reducing the revenue deficit, are required to strengthen the fiscal position on a sustainable basis.

CONCLUSION

Given a favorable external current account position and relatively disciplined government borrowings from SBP, the immediate risks to macroeconomic stability seem to have subsided, at least for the next two months. Therefore, SBP has decided to keep the policy rate unchanged at 14 percent. However, there is a little room for complacency as the risks to the economy may increase if meaningful economic reforms are not initiated to address the structural weaknesses. Inflation persistence still remains high, which is largely formed by recent past levels of inflation and perceptions of economic agents about the credibility and direction of monetary and fiscal policies in controlling inflation and promoting long-term sustainable economic growth. Perceived credibility of monetary policy is also influenced by the behaviour of monetary aggregates. In this respect, while government borrowing from SBP has been contained to end-September 2010 level, growth in public sector borrowing is still very high and that of the private sector low. Further, given the financing requirements of fiscal authorities, budgetary as well as non-budgetary borrowings for the procurement of commodities and addressing the circular debt-related issues, the likelihood of an ease in such borrowings is small. This means that risks to macroeconomic stability could increase in the next fiscal year. The current stability in the financial markets provides valuable time to initiate structural reforms.