Dec 5 - 11, 20

The central bank decided to adopt a cautious stance in its monetary policy review by keeping the current discount rate for the banks at 12 percent last week.

It may be recalled that in a surprise move the State Bank of Pakistan (SBP) had slashed the policy rate by 150bp in its earlier review in October 2011.

It is another thing that trade and industry pinned hopes for yet another cut of 50bps points because of 11-12 percent inflation, to this review of two months (December and January). Low interest rate helps in boosting up economic activities as it reduces cost of borrowing.

However, depleting reserves and mounting deficits kept the financial regulator a little cautious this time.

It is interesting to note that despite an aggregate cut of 200bps cut in discount rates in 2011, growth in private credit off-take remained muted. But, this was due to the government unabated appetite for banking funds as well as banks' longstanding reluctance to extend finances to private sector.

The current scenario calls for creating private sector's appetite for credit, which is extremely important to generate economic activities and the only way out to generate employment opportunities. Booming economic activities are the most effective way to combat street crimes more effectively than administrative steps taken by law enforcing agencies.

The situation calls for containing the government's borrowing from the banks, which is a primary trigger to inflation, or ensuring foreign flows to alleviate pressure on balance of payments and inject fresh rupee liquidity in the system.

SBP kept the rate unchanged after thoroughly considering the need to revive growth and emerging risks to macroeconomic stability.

It said the option of maintaining saving deposits or investments in investor portfolio securities (IPS) accounts could provide stiff competition to banks forcing them to offer better returns on deposits. 'This in turn would incentivize savings and help lower the currency in circulation,' it added.

A reassessment of latest developments and projections indicate that macroeconomic risks have somewhat increased during the last two months. For instance, although the year-on-year CPI inflation stood at 11 percent in October 2011, the month-on-month inflation trends, averaging at around 1.3 percent per month during the first four months of FY12, show existence of inflationary pressures.

The CPI items exhibiting year-on-year inflation of more than 10 percent, generally, belong to the non-food category. The government also increased its wheat support price by Rs100 to Rs1050 per 40kg for the next wheat procurement season. That may increase price of staple

While the average inflation may settle around the targeted 12 percent for FY12, it is uncertain that inflation will come down to a single digit level in FY13.

The main determinants of this inflation behavior are government borrowing from the banking system and inertial effects of high inflation on its expected path.

The severe energy shortages are also holding back the effective utilization of productive capacity.

On the external front, the earlier comfortable external current account position for FY12, which helped SBP in lowering its policy rate, has become less benign. The actual external current account deficit of $1.6 billion for the first four months of FY12 is now higher than the earlier projected deficit for the year. The main reason for this larger than expected deterioration is the rising trade deficit.

In particular, the windfall gains to export receipts due to abnormally high cotton prices in FY11 have dissipated faster than anticipated. This is indicated by slightly less than $2 billion per month export receipts in September and October 2011.

At the same time, international oil prices of around $110 per barrel and strong growth in non-oil imports have kept the total import growth at an elevated level of close to $3.4 billion per month. Adding to the challenges faced by the external sector is the precarious global economic outlook.

A relatively larger external current account deficit in FY12 would require higher financial inflows to maintain foreign exchange reserves.

However, during July-October FY12, the total net direct and portfolio inflows were only $207 million while there was a net outflow of $113 million in official loans. Consequently, SBP's liquid foreign exchange reserves declined to $13.3 billion at end-October 2011 compared to $14.8 billion at end-June 2011.

Given the scheduled increase in repayments of outstanding loans in H2-FY12, realization of substantial foreign flows, especially the proceeds of assumed privatization receipts, euro bond, coalition support funds, and 3G license fees, become important for strengthening the external position.

A reflection of widening external current account deficit and declining financial inflows can be seen in the reduction of Rs115 billion in the net foreign assets (NFA) of SBP’s balance sheet during 1 July-November18, 2011. This implies that to meet the economy's prevailing demand for money, SBP has to provide substantial liquidity in the system, at least to the extent of compensating for the declining NFA of SBP.

As of 28 November 2011, the outstanding amount of liquidity injected by SBP through its open market operations (OMOs) was Rs340 billion. This is significantly higher than normal SBP operations and appears to have developed characteristics of a permanent nature at this point in time.

It must be understood that there are uncertainties involved in realizing the full benefits of these measures. These uncertainties can potentially have adverse effects on SBP’s recent efforts to support private sector credit and investment in the economy.