After cumulative rate cuts of 200bps at its previous two meetings, State Bank of Pakistan (SBP) has struck a note of caution about the government’s medium-term outlook, warning that inflationary pressures are building again. This was anticipated by Sayem Ali and Nagraj Kulkarni of Standard Chartered Bank in their Global Research preview. At its 30 November meeting, SBP kept policy rates on hold, with the overnight deposit and lending rates unchanged at 9 per cent and 12 per cent, respectively.
SBP says macroeconomic risks have increased since the October meeting, with inflation remaining high and the Pakistani rupee (PKR) coming under renewed pressure. Headline inflation printed at 11 per cent y/y in October, up from 10.5 per cent in September. According to SBP, inflation will accelerate in 2012 because of a weaker PKR, rising electricity tariffs, and a higher wheat support price (the price at which the government will buy from producers). There is also a risk that the government will resort to printing money to finance its large deficit as markets demand higher premiums on Treasury bills and Pakistan Investment Bonds (PIBs).
The global economy has also deteriorated, leading to a sharp slowdown in export growth and capital inflows. The government has had to shelve plans to tap credit markets, kick-start the privatisation programme and attract investment through the auction of 3G licenses.
FX reserves declined to USD 13.3bn in November from USD 14.8bn in June. PKR has come under renewed pressure, trading at 88.75 to the US dollar on 30 November versus c.86.00 at end-June. It is likely to face more headwinds in 2012 because of large external debt payments, including repayments to the International Monetary Fund (IMF).
Markets were pricing in a 50bps cut and yields would likely inch higher in response to such a decision by SBP. In our view, the rate-easing cycle has come to an end, with little room in the near future to bring rates down further. ‘We expect SBP to keep rates on hold in Q1-2012, with a strong possibility that rising inflation will force it to hike as early Q2-2012,’ they added.
Growth outlook remains weak
The analysts say that the growth outlook remains weak: IMF projects 3.5 per cent y/y growth in FY12, lower than the government target of 4.2 per cent. The key concern is the slowdown in export growth owing to a decline in cotton prices and weak credit growth. Despite 200bpsworth of policy rate cuts since July 2011, private-credit growth had slowed to 1.6 per cent y/y by 11 November, from 5.5 per cent y/y at the end of 2010. This is primarily because of heavy government borrowing from banks, leading to a crowding out of private-sector credit. Private-sector investment spending declined to 8.5 per cent of GDP in FY11 (year ending 30 June 2011), from 15 per cent in FY08, mainly owing to a debilitating power crisis, political and security concerns and risk aversion by banks. After posting record export growth of 29 per cent y/y in FY11, Pakistan’s exports have slowed markedly so far in FY12. Export growth fell to 8 per cent in October 2011, mostly owing to a decline in commodity prices (exports are heavily concentrated in cotton and textiles) and the weak global economy. The analysts believe that ‘export receipts are likely to decline to USD 24.2bn in FY12, down 5 per cent y/y from USD 25.4bn in FY11. This will impact manufacturing sector output and lead to lower growth. Hence, in 2012, SBP will have to balance inflation risks against concerns about weak growth.’
Inflation to print higher in 2012
Headline inflation has declined so far in H2-2011 mainly because of the base effect of high inflation in the same period last year, owing to flood damage to food crops. Changes introduced in the benchmark consumer price index (CPI) index are also a factor; these include a reduction in the weightings of food and energy commodities –the key inflation drivers over the last four years. Headline inflation declined to 10.5 per cent y/y in September 2011, its lowest level in the last two years. However, SBP notes that inflation has remained high, with rising core inflation indicating a build-up of inflationary pressure. In October, CPI inflation accelerated to 11 per cent y/y from 10.5 per cent in September. SBP is “uncertain” that inflation will come down to single digits in 2012, as targeted by the government, and has maintained its FY12 inflation forecast at 12 per cent. This implies that CPI inflation will rise in 2012, driven mainly by a weaker PKR and an expansionary fiscal policy. Decisions such as a 10.5 per cent increase in the wheat support price will add to food inflation.
PKR weakness is the greatest concern
After a strong H1-2011, PKR has come under significant pressure so far in H2 on a widening trade deficit and large external debt payments. A slowdown in private capital flows and aid inflows from the US government and multilateral institutions has also increased pressure on PKR, which has depreciated 5 per cent year-to-date to 88.8 (30 November) against the USD, from 84.5 in December 2010. ‘We anticipate a further 6per cent correction in 2012, and forecast USD-PKR at around 94.0 at end-2012. The C/A deficit widened to USD 1.6bn during July-October 2011 from USD 541mn in the same period last year. This was mainly caused by a sharp drop in commodity prices, with Pakistan’s exports heavily concentrated in cotton and textile products. In FY12, we expect export receipts to decline by 5 per cent y/y to USD 24.2bn from USD 25.5bn in FY11,’ they said. However, expansionary fiscal policy and an accommodative monetary policy are leading to higher import demand. The import bill increased to USD 13.4bn during July-October, up 23 per cent y/y from USD 10.9bn in the same period last year. Pakistan’s external vulnerabilities arise mainly from the growing demand for energy; the oil bill rose sharply by 55 per cent y/y during July-October owing to rising prices and growing reliance on oil imports to meet energy demand. At its 30 November meeting, SBP warned that the widening C/A deficit is higher than its earlier forecasts and financing it will remain a challenge, owing to a slowdown in FDI and official aid inflows. SBP FX reserves declined to USD 13.3bn at end-October from USD 14.8bn in June, and will also come under pressure in FY12 because of higher external debt payments, including repayments to the IMF of USD 1.2bn. Total debt repayments are a hefty USD 4.2bn in FY12, and could rise to USD 5bn in FY13. Pakistan will struggle to both retire the IMF loan and maintain its FX reserve position.
Weak finances pose inflation risks
Markets’ main concern is the sharp build-up of debt and the government’s inability to meet its budget targets. The government is likely to overshoot the FY12 budget target of 4 per cent of GDP; we forecast a deficit of at least 6.5 per cent if revenue measures do not yield the desired results. Financing this large deficit will be a challenge, especially with official aid flows slowing and the privatisation programme stalled. Government borrowing from banks increased sharply to PKR 631bn (3 per cent of GDP) from July to 18 November 2011, higher than PKR 606bn borrowed during FY11. This level of borrowing has been possible because of SBP’s liquidity injection of PKR 304bn (1.5 per cent of GDP). However, SBP says this has developed the “characteristics of a permanent nature”, and will fuel inflation going forward. With rates kept on hold at the 30 November meeting, markets will now demand higher premiums to hold government paper. This could force the government to print money to finance its large deficits, fuelling inflation.
Markets disappointed
The rates market – which had been expecting monetary easing to continue –responded negatively to the policy announcement. The benchmark 10Y PIB yield spiked by c.60bps and the curve bear steepened by c.40bps. They say we see this response as a recalibration of the rates market’s expectations on the trajectory of policy rates. Although the central bank has switched its focus to price stability, we do not expect the next rate hike before Q2-2012. Until then, concerns about the impact of fiscal slippage on market borrowing will likely keep the market vigilant. If the recent trend of increased government dependence on domestic funding sources – particularly envisaged from commercial banks – to finance the deficit slippage continues, then the banking system will likely demand a further premium to absorb the additional supply. We note that the banking system’s excess holding of government securities (beyond mandated) is at a three-year high. We expect yields to remain range-bound ahead of the next rate hike, as expectations of continued supply are likely to offset the implied support generated by the stable policy-rate environment.
