Challenges on external, fiscal side haunting macroeconomic stability


The country’s fragile economy is, whereas, showing signs of a modest improvement on the back of positives in agriculture and services sectors, the central bank is foreseeing in Pakistan some serious challenges to macroeconomic stability stemming from the external sector and continued weaknesses on the fiscal side.
“Half way into FY12, the economy is showing signs of a modest improvement,” said the State Bank in its second quarterly report for July-December FY12 issued on Tuesday.
Referring to preliminary data, the bank said the commodity producing sector, especially agriculture, was doing better than expected while the services sector also seemed well-placed to gain from robust retail trade activities, transportation and increased profitability of the banking sector.
The ample availability of key staple crops and less than anticipated supply disruptions due to floods played a key role in containing inflationary pressures during the period under review.
However, the benefits of productivity gains to farmers are being eroded by the dwindling price of their produce and the increased cost of inputs, especially that of fertilizer. “Accordingly, farm income is expected to be lower than last year.” Despite these positives, the SBP warned, risks to macro-economic stability had, nevertheless, increased in the crises-hit country. Specifically, the SBP said, the position of the external sector weakened at a rate faster than expected and that the fall in financial and capital inflows exerted pressure both on the banks’ foreign exchange reserves as well as the rupee.
“This, along with the pickup in government borrowing from SBP, complicated liquidity management,” the bank noted with concern.
Finally, it said, the energy shortages continued to plague production activities, especially in the
industrial sector.
Giving a future outlook, the central bank said the economy was expected to grow in the range of three to four percent during FY12. Within aggregate demand, there has been almost no improvement in the investment component, despite the reduction in the cost of borrowing, following the cut in SBP’s policy rate.
Loans to private sector businesses expanded only by 3.5 percent in H1-FY12, with fixed investment loans seeing a net retirement of Rs 8.5 billion, the bank said. “The low demand for fixed investment loans is largely due to persistent energy shortages, the unfavorable law and order situation, and excess capacity in the industrial sector,” the bank said. Amid low demand, the working capital loans had increased by Rs 99.5 billion during H1FY12 compared to last year’s Rs 131.3. The SBP said the government had to purchase 378,000 tons of sugar through TCP to help sugar mills, which were unable to offload their stocks from last year, retire some of their bank borrowings. The inflationary outlook had improved slightly on account of supply side factors (food) and FY12 was expected to see inflation fall within the range of 11.0 to 12.0 percent, with a bias towards the lower boundary. “More than half of the commodities in the CPI basket are still posting double-digit inflation,” the bank said. About the fiscal deficit, the SBP said despite seeing the gap on lower level during H1-FY12, containment of the overall deficit at the revised target of 4.7 percent would be challenging for the government.
“Quarterly data for previous years has shown that the deficit remains relatively higher in the second half of the year,” it said. Adding the achievement of the revised fiscal deficit was dependant on the realization of envisaged surpluses from provincial governments (which are likely to be lower than expected), the non-tax revenues (depending on inflows into the Coalition Support Fund) and the auction of 3G licenses and strict control over expenditures. The burden of financing this deficit, the State Bank said, would fall on the banking system, specifically on commercial banks. “Other than growing concerns about the supply of loan-able funds for the private sector, renewed government borrowing from SBP entails rising inflationary expectations in the economy,” it added.
Terming the composition of government borrowing, which accumulated at Rs 391.0 billion and has tilted towards inflationary financing, as of a greater concern, the SBP said the government was unable to meet its self-imposed quarterly limit of zero net budgetary borrowing from SBP. On the external front, although the current account deficit was expected to be in the range of 1.5 to 2.5 percent of the GDP, there was an upward bias to this prediction. “Given the fall in financial and capital inflows, funding this modest current account deficit could be challenging,” it said adding the market players were increasingly concerned about whether the envisaged foreign inflows would materialize in time. This, together with the scheduled repayment of IMF loans, amounting to $ 1.1 billion, during the second half may draw down the SBP’s foreign exchange reserves.
Data for consolidated fiscal operations indicates a deficit of 2.5 percent of GDP for H1-FY12. The good news is that this came primarily from the revenue side; FBR tax collections reached Rs 840.1 billion during H1-FY12, showing a YoY growth of 27.1 percent.
Moreover, SBP profits of Rs 104.0 billion contributed significantly non-tax revenues. Nevertheless, it is important to note that financing this contained fiscal deficit in H1-FY12 was challenging as compared to H1-FY11.
The slowdown in foreign exchange inflows has also raised concerns about country’s balance of payments. Specifically, Q2-FY12 data shows that the overall external account deficit has increased to $ 1.0 billion compared to $ 0.8 billion in the first quarter of the year. “The composition of the BoP reveals that the current account deficit has widened to $ 2.2 billion against an almost nil balance during H1-FY11,” said the State Bank.
Counting $ 6.3 billion worker remittances the only positive on the list, the bank said all other components of the current account deteriorated during the review period. The import bill increased on account of higher international oil prices and the import of fertilizer which accounted for 60 percent of the increase. On the other hand, export growth has slowed to 3.9 percent compared to 18.9 percent during the first half of the previous year. The financial and capital accounts posted a deficit of $ 0.4 billion during Q2-FY12. Hence, the SBP’s dollar reserves saw a reduction of $ 1.9 billion during H1-FY12 to $ 12.9 billion. This decline in reserves was accompanied by a depreciating Pak Rupee, which lost 4.4 percent of its value during the first half of the year, said the bank.
“Despite these weaknesses, the size of the current account deficit should not be a major source of concern, given Pakistan’s history. The real challenge is financing the current account deficit, as both debt and non-debt inflows have declined,” the State Bank said.