SBP keeps policy rate unchanged

Terming financing of country’s fiscal and external current account deficits as a basic challenge, the central bank Saturday kept the discount rate unchanged at the pre-2008 level of 12 per cent to revive business confidence in the crises-hit country.
State Bank, declared achievement of the budgeted Rs1.952 trillion tax collection targets as “ambitious” and projected that the fiscal deficit was difficult to be arrested at revised target of 4.7 per cent and was likely to swell beyond 5.5 per cent of the GDP by the end of FY12. Citing provisional estimates, the central bank said the fiscal deficit for H1-FY12, from the financing side, showed a deficit of Rs532 billion or 2.5 per cent of GDP. Given that the fiscal deficit was always higher in the second half of a fiscal year, at least by 0.5 per cent during the last 10 years, containing the FY12 fiscal deficit close to the government’s revised target would be difficult. The regulator said given a steady flow of workers remittances, the external current account deficit is expected to remain in the range of $3.5 billion to $5.5 billion, or 1.5 to 2.4 per cent of GDP, by end-June. “Central Board of Directors of State Bank of Pakistan (SBP) has decided to keep the per cent policy rate unchanged at 12 per cent,” Governor SBP, Yaseen Anwar, announced here at SBP while unveiling the Monetary Policy Statement for the next two months.
Projecting the backbreaking inflation (average) to remain in double-digit, ranging from 11 to 12 per cent, for the current fiscal year, SBP governor said there were indications of underlying inflationary pressures in the economy on account of non-food CPI items. Suggesting the Medium Term Budgetary Framework (MTBF) as imperative to check the persistent price hike, Anwar said, energy-shortages related uncertainties would have to be lessened to ensure a sustainable economy recovery in the country.
“It must be emphasised that sustainable economic recovery over the medium term would call for a sizeable increase in both the domestic and foreign private investment in the economy. For this to happen, the business confidence needs to be revived by reducing uncertainties due to energy shortages,” the governor said. Against this backdrop, he said, SBP’s central board considered the early rate cuts of 200 basis points to be appropriate. About the financial deficits on the domestic and external fronts, Anwar said, the size of these deficits may not be considered large, given the current state of falling private sector investment demand in the economy. A reflection of overall low aggregate demand could be seen in the declining inflation trend, contraction in the real private sector credit, and falling volume of imports.
According to SBP governor, lack of diversified and sustainable financing sources had resulted in substantial government borrowings from the banking system and declining foreign exchange reserves. “This has squeezed the availability of credit for the private sector and increased the pressure on rupee liquidity.” SBP, he said, had been providing substantial liquidity on almost permanent basis, on average Rs230 billion during 1st July–9th February 2012, to ensure smooth functioning of the payment system and avoid financial instability.
“The continuation of this trend, however, carries risks for effectively anchoring inflation expectations in the medium term,” he warned.
The uncertain market liquidity flows have lead to excess volatility in short term interest rates and increased the challenges of monetary management. The main reasons for this uncertainty include, a sharper deterioration in the external current account deficit, a declining trend of foreign inflows, and a higher currency to deposit ratio.
However, other market interest rates, such as KIBOR and Weighted Average Lending Rate (WALR), have largely followed the policy rate reductions.
A declining interest rate environment together with a relatively better growth in Large-Scale Manufacturing (LSM) is expected to help the pickup in private sector credit. The LSM sector grew by 1.5 per cent during July-November, FY12, which is in contrast to an average contraction of 3.1 per cent during the same period of last three years.
Moreover, credit to the private sector has expanded by Rs238 billion during 1st July–3rd February, FY12.
However, to assess its likely path, few points need to be kept in mind. First, given the continuing energy shortages, unfavourable law and order conditions, and an uncertain political environment, the desired boost in business confidence and thus private sector credit may not take place. Second, profitability of the textile sector, a major user of private sector credit, was better in FY11 due to higher cotton prices. This would facilitate repayments or keep the demand for fresh credit to a minimum in FY12. Third, the utilisation of installed industrial capacity is considerably low and continues to decline, which is inhibiting credit demand for fixed investment. Fourth, all of the fresh credit disbursement in H1-FY12 was utilized to meet the working capital requirements, which implies that a significant part of this credit will be retired in H2-FY12. “Thus, the full year expansion in credit to the private sector is expected to remain weak for yet another year in FY12 despite interest rate reductions,” said the governor. He said its year-on-year growth was already negative in real terms and indicated depressed private investment demand in the economy. In addition, the governor said, given substantial government borrowings from the scheduled banks together with rising bad debts, the banks were likely to continue to avoid lending to the relatively risky private sector.
Citing provisional data, he said the government had borrowed Rs444 billion from the banking system during 1st July–3rd February to finance its current year’s fiscal deficit.
This includes Rs197 billion borrowed from the SBP and show a year-on-year growth of 25.8 per cent.
Moreover, he said, these borrowings were significantly higher than the yearly financing requirements of Rs293 billion envisaged in the FY12 budget. About tax collections, SBP governor termed as encouraging the Federal Board of Revenue’s collection of Rs840 billion during H1-FY12, showing a strong growth of 27.1 per cent, and the announcement of auctioning 3G licenses in the telecommunication sector saying these developments could help country contain the potential fiscal slippages.
“However, based on the seasonal pattern of tax collections, the full year target of Rs1952 billion still seems ambitious,” he viewed.
At the same time, Anwar said, there were indications that the issue of circular debt in the energy sector remained and losses of major Public Sector Enterprises (PSEs) continued to increase. Thus, the likelihood of slippages on the expenditure side on account of subsidies, over and above the budgeted amount, cannot be ruled out. The delay in these subsidy payments may have implications for resolving the circular debt issue. About the external sector, SBP governor said, the risks to external position had also increased due to worsening terms of trade, fragile global economic conditions, and continued paucity of financial inflows.
In addition, $1.1 billion were scheduled to be repaid to IMF during the second half of FY12. SBP’s foreign exchange reserves had already declined to $12.2 billion as on 9th February 2012 from $14.8 billion at end-June 2011. Similarly, the rupee-dollar exchange rate had depreciated by 5.2 per cent in FY12, so far.
Led by 33.7 per cent growth in imports of petroleum products on the back of elevated international oil prices, total imports have increased to $19.7 billion in H1-FY12. The volume of imports remained muted, which indicates moderation in domestic demand pressures. Given the rising tensions in the US-Iran relations and political uncertainty in the Middle East region, oil prices are unlikely to fall significantly in the near future and may even increase. “Therefore, despite low volumes, imports are projected to grow in the range of 12.5 to 14.5 per cent for FY12,” he said. While the falling cotton prices played their part in sharper than expected slowdown in export receipts, $12 billion in H1-FY12, the volume of exports had also declined considerably. “Assuming that these trends would continue in H2-FY12, export receipts are projected to show a decline of 3 to 5 per cent in FY12.” Projecting the country’s external current account deficit at $3.5 billion to $5.5 billion, SBP governor said, the possibility of limiting the deficit to the lower bound of the range was mainly contingent upon the realisation of Coalition Support Fund, $800 million, and the proceeds from the auction of 3G licenses, estimated to be around $850 million. “The real challenge is to finance this projected external current account deficit,” he added. The actual net capital and financial inflows during H1-FY12 was only $167 million, due to the decline in both direct and portfolio investments and shortfalls in
official flows.
Assuming that all the official flows contemplated by the government are realised–$500 million from the issuance of euro bonds, $800 million from the privatisation proceeds of PTCL, and budgeted loans from international financial institutions–the net capital and financial inflows could increase to $3.8 billion by June, 2012. These fiscal and external developments, he said, had resulted in a skewed composition of monetary aggregates. In particular, the increase in Net Domestic Asset (NDA) component of M2 was disproportionately large while Net Foreign Assets (NFA) had contracted. Given its strong correlation with inflation, the resulting increase in NDA to NFA ratio was not a welcoming development, he said adding the Year-on-Year growth in M2 for FY12 was projected to be in the range of 12 to 13 per cent.
The changing composition of M2 required a careful interpretation. For instance, the deterioration in the external sector was mostly due to adverse terms of trade developments and uncertain official inflows and may not be a sign of rising aggregate demand. Similarly, the pressure on aggregate demand due to the government borrowings from the banking system was being partly offset by the weak private investment demand. These conjectures were supported by the decline in Year-on-Year CPI inflation to 10.1 per cent in January, 2012. He said the average inflation in FY12 would increase and was expected to remain in the range of 11 to 12 per cent, due to an increase in electricity and gas prices, high international oil prices, impact of exchange rate pass-through, increase in support price for the upcoming wheat procurement season, and substantial government borrowings from the banking system. MTBF, he said, envisaged a systematic reduction in the fiscal deficit to 3.0 per cent of GDP in FY14, by increasing the tax to GDP ratio and stipulates inflation targets of 9.5 per cent for FY13 and 8 per cent for FY14. Decisive reforms in the energy sector can also go a long way in achieving MTBF targets.
These reforms would not only reduce the government’s reliance on the banking system borrowings, but also minimise the need to adjust the energy prices in a sporadic and unpredictable manner.
To sum up, he said, despite moderate aggregate demand, pressure on rupee liquidity was likely to continue due to uncertain foreign inflows and substantial government borrowings to finance the fiscal deficit.