Central bank, which announced to keep the interest rate unchanged at 12 per cent for next two months, finds itself in a “dilemma” as the cash-strapped government appears to be the main user of banking system’s liquidity and the banks are hesitant to extend credit to the growth-oriented private sector. Excluding the issuance of Rs391 billion government securities to settle lingering circular debt and commodity loans, the funds-starved government borrowed Rs317 billion from central and scheduled banks during July to 18th November 2011 to fund its ever-burgeoning budgetary expenditures.
Injecting monetary penicillin
And State Bank has to pump “substantial liquidity” in banking system to cater to this prevailing demand for money. By 28th November this year, the outstanding amount of liquidity injected by State Bank stands at Rs340 billion. On the other hand, the risk-averse banks’ credits to growth-oriented private sector remain “muted” so far. Regulator is in a kind of fix as it helplessly says any effort to scale down ongoing abnormal liquidity injections could have implications for settlement of payments in the inter-bank market. “In this context where government is the main user of the system’s liquidity and banks remain hesitant to extend credit to the private sector, SBP faces a dilemma,” central bank said in its monetary policy decision.
Interest rate static
Regulator announced to keep interest rate static at 12 per cent in view of, what the policymakers said, a pressing need to revive growth and emerging risks to macroeconomic stability. The decision was taken by Central Board of Directors of State Bank of Pakistan, who met under chairmanship of Governor Yaseen Anwar to decide fate of discount rate for the next two months, January and February. “SBP reduced its policy rate by 200 bps, to 12 per cent, in FY12 so far. The objective of adopting this stance is to support revival of private investment in the economy despite a constraining domestic and global economic environment,” the bank said in its MPD. It said primary factors in support of this stance were expectation of average CPI inflation remaining within announced target in FY12 and a small projected external current account deficit. In pursuing this stance SBP did acknowledge risks to macroeconomic stability emanating from fiscal weaknesses and falling foreign financial inflows.
Non Oil imports Rise
At the same time, SBP said, international oil prices of around $110 per barrel and strong growth in non-oil imports had kept 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,” it said. State Bank said 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.
Inflationary pressures
Adding a reassessment of latest developments and projections indicated that macroeconomic risks had somewhat increased during the last two months. For instance, although the year-on-year CPI inflation stood at 11 per cent in October 2011, the month-on-month inflation trends, averaging at around 1.3 per cent per month during the first four months of FY12, showed existence of inflationary pressures. SBP said shifting of commodity level CPI data revealed that number of CPI items exhibiting year-on-year inflation of more than 10 per cent was consistently increasing and almost all of these items belonged to non-food category. “The government has also increased its wheat support price by Rs100 to Rs1050 per 40kg for the next wheat procurement season,” it said. Thus, the bank said, while average inflation might settle around the targeted 12 per cent for FY12, it was uncertain that inflation would come down to a single digit level in FY13.
current account deficit
Severe energy shortages were also holding back effective utilisation of productive capacity and adding to the high inflation-weak growth problem. On the external front, the earlier comfortable external current account position for FY12, which helped SBP in lowering its policy rate, had become “less benign”. Actual external current account deficit of $1.6 billion for the first four months of FY12 was now higher than earlier projected deficit for the year, central bank observed. “The main reason for this larger than expected deterioration is the rising trade deficit”. In particular, windfall gains to export receipts due to abnormally high cotton prices in FY11 had dissipated faster than anticipated.
Non Oil imports Rise
At the same time, SBP said, international oil prices of around $110 per barrel and strong growth in non-oil imports had kept 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,” it said. State Bank said 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.
SBP foreign reserves
As a consequence, SBP’s liquid foreign exchange reserves have declined to $13.3 billion at end-October 2011 compared to $14.8 billion at end-June 2011. Given scheduled increase in repayments of outstanding loans in H2-FY12, realisation of substantial foreign flows, especially the proceeds of assumed privatisation receipts, euro bond, coalition support funds, and 3G licence fees, becomes important for strengthening the external position.
Net Foreign Assets drop
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 July to 18th November 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,” the bank said. About its money injection operations, the bank said, as of 28 November 2011, the outstanding amount of liquidity injected by SBP amounted to 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,” the bank said. It said a dominant source of demand for money and thus liquidity injections by SBP was government borrowings for budgetary support from the banking system. SBP said while government had borrowed Rs317 billion from the banking system, the banks’ credit to the private sector was muted.
Private sector credit to improve
Growth in private sector credit, it said, might pick up in coming months as the desired effects of a cumulative decrease of 200 bps in policy rate and reduction in financial constraints of the energy sector gather momentum. “In this context where government is the main user of the system’s liquidity and banks remain hesitant to extend credit to the private sector, SBP faces a dilemma,” the bank said. Efforts to scale down liquidity injections could have implications for settlement of payments in inter-bank market. Even if these considerations are addressed, government may end up settling its obligations by borrowing from SBP. The marginally increasing trend of these injections, on the other hand, also carries inflationary risk.
Tax reforms and foreign inflows
There are three solutions to this predicament of reconciling price and financial stability considerations and supporting private investment in the economy. First, government needs to ensure that all or major parts of budgeted foreign inflows materialise as soon as possible. This will alleviate pressure on balance of payments and help inject fresh rupee liquidity in the system. Second, sooner than later government would have to initiate comprehensive tax reforms that broadens the tax base of the economy. This is of paramount importance to reduce government’s borrowing requirements. Third, efforts need to be stepped up to improve financial deepening and increase competition in the banking system. The last of these solutions is something that SBP has been actively working on encouraging depositors to invest in government securities through IPS accounts, the bank concluded.