KARACHI: Alarmed by perennial economic threats like excess money creation and the looming threat of heavy inflation, the State Bank of Pakistan (SBP) revealed on Monday that the government had borrowed 86.3 percent or Rs 266 billion of the total Rs 308 billion expanded reserve held during the current fiscal year.
The central bank is also concerned that economic variables like inflation, fiscal overspending and unresolved issues in the power sector were hampering stabilisation and hurting the growth of the fragile economy. Furthermore, the SBP acknowledged that problems like soaring security and flood-related expenditures, power sector subsidies, a narrow tax base and a declining tax to GDP ratio were magnifying the fiscal challenges.
This was observed by the Central Board of Directors of SBP in its Monetary Policy Decisions issued on Monday for the next two months of Fiscal Year 2010-11.
The board noted that high inflation persisted primarily because money creation was well in excess of production activity. Government borrowing, it said, had stoked fears of rampant inflation, resulting in high interest rates.
“The nature of this fiscal expansion is the root cause of high inflation in Pakistan,” the Board observed.
Therefore, the Board admitted, it would be difficult to curtail inflation unless government reliance on the SBP was reduced substantially. “The economy’s ability to achieve sustainable recovery remains constrained due to the slow pace of reforms,” it added.
The Board stated that, while adjustments in the prices of fuel and energy and the post-flood disruption in the supply chain of food items had contributed to the recent upturn in inflation, the high level of government borrowing from the SBP was diluting the effect of monetary policy in containing inflation. Apprehension that these supply shocks will dramatically worsen the outlook on inflation have not materialised, it pointed out.
“The cost to the economy is being paid through erosion in the purchasing power of the rupee, growing debt, and discouragement of private sector activity,” it said.
“Temporary price hikes in the food category, as seen in a monthly increase of over five percent during August and September 2010, have somewhat subsided. As a result, in October 2010, CPI inflation posted a marginal annual decline of 0.4 percent, while a 0.6 percent growth on month-on-month basis was well below last year’s average.”
On the other hand, the Board said, the persistent component of inflation remained sticky at over 12.5 percent in annual terms since January 2010 and had increased to a one percent monthly change in October 2010, with further increases feared.
“An important source of this stickiness is the expectation that the government will continue to rely on the SBP to finance its deficit. Indeed, the correlation between inflation and the government’s gap in financing is no coincidence.”
Government borrowing from SBP at an accelerated rate reflects severe fiscal vulnerabilities, it warned. Given delays in the introduction of tax reforms and weak industrial production, the task of achieving a 27 percent increase in tax revenues during FY11 is becoming an unrealistic proposition, it observed.
The government has voiced its intention to widen the tax net through introduction of the reformed General Sales Tax (GST) along with other tax measures and effectively contain power sector subsidies. The board apparently believes that this could potentially alleviate inflation concerns in the medium, reduce the cost of borrowing and pave the way for economic growth. It cautioned that it may be some time before the benefits of such measures is felt.
But pressing flood-related expenditures and shortfalls in external financing of the budget have increased reliance of the government on domestic sources.
Touching on commercial banking, the seasonal increase in the working capital credit requirements of the private sector during the second quarter is also higher due to higher input prices and putting pressure on the banking system; interest rates have risen. With low growth in the banking system and deposits, liquidity management has also become challenging.
Therefore, to further encourage the private sector, fiscal authorities need to demonstrate greater resolve in implementing a strategy to contain the fiscal deficit through fundamental structural reforms.
“However, the recent rejection of two PIB auctions in Q1-FY11 and acceptance of Rs 50 billion instead of Rs 90 billion offered by the banks in the T-bill auction on 16 November, 2010 is apparently inconsistent with stated intentions,” the Board stated.
It said assuming a real GDP growth of 2.5 percent and the expected decline in private and public sector investment expenditures would be largely compensated for by increases in public sector consumption expenditures, the external current account deficit is likely to be narrow in FY11. Helped by higher cotton prices, export earnings of $7.1 billion during first four months of the current fiscal year seem fairly encouraging.
Similarly, recent trends in remittances coupled with expectations of Coalition Support Fund (CSF) receipts could prove to be quite useful in meeting import bills.
“Monetary policy is essentially a short term instrument with which emerging risks are managed. The impact of monetary policy on economic activity and inflation is indirect and operates with a lag, and unlike the case of fiscal policy that tends to be reactive, it has to be proactive,” the Board maintained.
“The real test lies in continuing the financing of the external current account deficit. Assuming that projected external inflows for FY11 do materialise, substantial growth in private foreign inflows would be required to maintain and bolster foreign exchange reserves.” It said that under present circumstances, if the expansionary fiscal position was not expected to translate into a current account deficit during the current fiscal year, then it could be the a sign that private sector demand was muted.
“Therefore, the monetary stance could probably remain unchanged.” However, inflation was rising on the back of relentless government borrowing. “The rising NDA to NFA ratio of SBP balance sheet and its strong association with CPI inflation also suggest that inflation is likely to persist at double digit levels during much of FY11 and possibly in FY12.
SBP efforts to counterbalance the rapid expansion in reserve money and arrest the rising inflation expectations would require an increase in the policy rate.
After careful consideration of this trade-off, SBP has decided to increase the policy rate by 50 basis points to 14 percent with effect from 30 November, 2010,” it concluded.
