Sep 17 - 23, 20

One of the core reason that has impacted Pakistan is inflation which has pushed the middle class below the poverty line and have further resulted in riots and revolts across Pakistan. The government was not able to curtail inflation which is expected to remain in double digits through FY13. The tax base is poor since the government does not have the mechanism to collect taxes since large part of the economy is undocumented and mostly unbanked. Pakistan is in a situation where in addition to lower tax base exports are half of that of imports. To finance the expenditure, the government has resorted to either borrowing from World Bank or Asian Development Bank being international advances denominated in US Dollars along with borrowing from the banking system offering an attractive rate of return which considered risk free. With devaluation of the exchange rate against the dollar, the net outstanding in rupee terms against the US denominated loans automatically increases the debt to be repaid.

During the current year, the outstanding stock level of government securities reached Rs. 1,662 billion by August 2012. The year-on-year growth in the private sector credit was only 4.2 percent. Since government securities yield a healthy risk free return, banks continue to prefer financing government's deficit through investment in fixed income securities rather than focus more on taking risk and extend private sector credit. The reduction in the policy rate is expected to give respite to companies highly leveraged and may encourage lending by the banks to help develop the private sector to improve GDP. Banks are considered financial intermediaries bridging the gap between borrowers and lenders through demand of money. Residual funds or deposits are placed in short term government securities with tenors ranging from 3months, 6months and 1 year to yield a healthy risk free return as part of banks ongoing strategy.

Before reduction in the discount rate by 150 bps, T-Bill auctions have yielded between 11.8 percent to 12 percent return which forces banks to be resilient with such investments rather than lending to consumers or private sector. T-Bills auctions recently and the next auction on 19-Sep-12 is expected to offer a yield around 10.3 percent. Despite the reduction in rate, banks continue to place funds in money market instruments. SBP has time and again in every monetary policy review and decision has encouraged the government to increase the tax base and limit borrowings from the banking system which results in an increase in interest rates for corporates and consumers. According to an amendment in the State Bank of Pakistan Act 2012, government borrowing from the SBP is required to be repaid at the end of each quarter and the existing stocks to be retired within eight years starting from this fiscal year. This unfortunately is not being complied with by the government whereas maturing bills are replaced with new auctions thereby keeping the net effect of borrowing from the banking system same.

In addition to interest rate, another impact of government borrowing is inflation with excess flow of money in the economy which counters SBPs efforts to curtail inflation. There has remained significant speculation on Monetary Policy decisions by SBP based on economic aggregates to define the ongoing tools to be adopted to control inflation. The international oil prices continue to be volatile and frequently revised domestically.

The core cause of concern for SBP is government borrowing which have yet to be reduced. If oil prices decrease, any such decrease will be negated through the devaluation of rupee against the dollar which is likely to increase the import bill and causing inflation. CPI as on July 2012 stood at 9.60 percent with electricity, fuel and gas accounting for 29.41% of the CPI. A source for liquidity pressures in the economy is sluggish economic growth and foreign direct investments which could substitute low tax base. SBP stressed that the government must devise fiscal and energy sector reforms and plan foreign financial inflows to mitigate uncertainty and pressure on reserves.

Based on the latest Inflation Monitor report by SBP issued in August 2012, inflation is on a rise among all income levels and across most commodities and products used for daily consumption. Major increases have been witnessed among wheat, pulses, eggs, milk, sugar, fruits and vegetables which will continue to be volatile. In addition to government borrowing, the reasons for inflation in Pakistan are numerous some driven through supply while others driven through demand side pressures. Despite measures undertaken by the SBP to control the money supply, the government remains the single largest borrower from the banking sector through fixed income securities for deficit financing which again increases inflation. Budget deficit resulting in SBP borrowings is expected to remain below 5% of GDP though FY13. Pakistan with one of the lowest tax base in the economy.

The challenge for SBP with the Monetary Policy is to reduce inflation and encourage private sector lending alongside an attractive rate of return for depositors to counter rise in inflation. The Monetary Policy cannot work in isolation considering external shocks e.g. international oil prices, recessionary impact, devaluation in interest rates or government borrowings. It is however an encouraging sign that SBP wants to increase off take of advances through the banking channel through reduction in the Policy Rate. It is yet to be seen if advances, particularly in the Consumer Sector including Credit Cards, Home Loans, Auto Loans and Mortgages do actually increase. Pakistan is a net importer therefore any devaluation in the exchange rate against the dollar will make imports expensive and put further pressure on the reserves. Though exports due to such devaluation are expected to grow, however considering rise in input cost, such differential may be negated making prices unattractive for the export markets.

Financial Stability can be attained if the Government has the capacity to finance the budgetary deficit through own sources rather the reliance on the banking channel. In doing so, banks will be encouraged to lend and increase the advances relative to deposits which will assist in production, capacity enhancement and expansions leading to higher manufacturing capacity and improved GDP.