Rate cut: Slow and steady seems the way

Its the season of doves at the State Bank of Pakistan and a further cut in the policy rate is inevitable in the Monetary Policy Statement set to be announced on the coming Saturday. But the question, just how low will they go?
If inflation were the only indicator, then the current real interest rates are too high, averaging about 450 basis points compared to the historical average of 200-250 bps. Inflation is expected to slide further, possibly ending up around the five percent mark for the current fiscal. Based on that information, the discount rate should be slashed by no less than 150 basis points.
But don get too excited just yet. Restricting analysis to inflation outlook only can be costly in a country that has shown no resilience to balance of payments crises. The foremost factor shall be the build-up of foreign exchange reserves and the state of the current account.
There is hope that the current account will be in surplus during 2HFY15 and in the following fiscal given depressed international oil prices. But seeing the numbers is more comforting than running on premature expectations. The fear is that, by passing the full impact of lower oil prices and shortage of CNG (and thinning gap between CNG and petrol prices), the consumption of fuel in transportation may increase. The petroleum minister is already blaming a demand surge of 25-30 percent as the main reason for the countrys worst ever petrol crisis.
Additionally, many big corporations are heavily reliant on furnace oil for their captive power production (those who have FO-based plants) as producing electricity on it, is cheaper than what they are getting from the grid. If oil prices stay low, many more such firms will be inclined to import second-hand plants which are available in abundance in Europe at affordable rates.
There is also a case of LNG imports to provide an alternate to CNG for transport sector. The math is simple - the huge gap between the demand and supply of energy will induce higher supply at lower prices even if demand stays constant. Hence, the volumetric increase in oil may eat partial benefit of decline in oil prices. So, its better to tread cautiously and let the number to appear on surface.
This is evident from the fact that despite, on average, 25 percent decline in oil prices in the 2QFY15 the oil imports only marginally declined from $3.8 billion in 1QFY15 to $3.5 billion. Well, this asserts that more volumetric demand is the reason for it. But changes in oil prices usually impact on imports with a delay of 2-3 months so the ongoing quarter (3QFY15) will make the picture clearer.
The good omen is that imports may fall while reserves may pile up owing to financial and capital account inflows as $1.2 billion are expected to flow in from disinvestment of HBL. Apart from that, $700 million from Coalition Support Fund may also come in the second half. By virtue of materialization of these flows, the import cover may reach 3-3.5 months by June-end from the current 2.5 months of import cover.
By visualizing this, one may attempt to go for an aggressive cut in the policy rate given that all the macroeconomic indicators are improving but GDP growth. The high unemployment and low investment shall be the biggest worry for any economic manager in the medium to long term and policies should be devised to propel the growth momentum.
However, monetary policy is not the only tool to do so. Yes, credit to private sector is very low and monetary asset growth is half this year to date as compared to what it was in the same period last year. But the low investment rates are attributed to inefficient allocation of banking assets to government financing and until and unless the fiscal house is set in order, the issue may not be resolved.
Falling oil prices present an opportunity for government to curb its subsidy on electricity and raise higher taxes on petroleum products to lower the fiscal deficit and let banking deposits route to the private sector. However, in order to do so, policy makers must refrain from pro-public policies of passing on the entire impact to the consumers and learn from other oil importing countries which are pouncing on opportunities to enhance allocation towards development and social sector budgets.
Lowering interest rates rapidly can cause too much euphoria and may disturb the phenomenon of reserves building. The argument of cautious stance is augmented by the directive of the IMF, which is a clear proponent of keeping monetary policy in check to ensure stable recovery.
However, proponents of a dovish stance may argue that current account is already in surplus since December apart from below five percent inflation in the past two months. But they have to closely see the break-up of the current account as the surplus is coming from surge in current transfers while the imports are still high and exports have not picked up much.
The second quarter is encouraging with 16 percent fall in imports and five percent increase in exports from the first quarter numbers. However, comparison of first half with similar period last year is showing an opposite picture refraining policy makers from an aggressive cut option.
The given that oil prices remain low and current account would be in surplus over the next two years, the policy rate may become irrelevant in the process. Remember, that in FY02-04 period when the average yearly current account surplus was $2.4 billion (it was a very high number as the size of GDP was smaller relative to today) the policy rate became irrelevant. As policy rate was kept at 7.5 percent for most of that period but influx of liquidity drove the market interest rates to as low as 1 percent.
Hence, if the story of fall in oil prices and privatization inflows is as rosy as portrayed by advocates of low interest rates, the rates would come down anyway by market forces. So its better for SBP to remain behind the curve and lower the policy rate in a staged manner i.e. 50 bps in each policy review till July.
The market thinks in a similar way; out of 24 banks and research houses contacted by BR Research, 13 expect a 50 bps cut, six are expecting 50-100 bps cut while five respondents are in favour of 100 bps cut on Saturday.

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BR Research Monetary Policy Survey

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MPS Date   No. of Participant  Outlook                     Rationale on Concensus Basis

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                                                           Main consideration is the inflation

                                                           outlook being soft on the back of

                                                           sliding international oil prices.

                                                           This likely to bode well for imports.

                                                           Relatively healthy reserves position

                               13 = 50bps cut              and stable rupee dollar parity

                                                           provide room for SBP to opt for

Feb-14        24               5 = 100bps cut              monetary easing. However, pressures

                                                           from IMF will prompt SBP to stay

                               6 = 50-100bps cut           cautious and cut discount rates

                                                           gradually. GDP growth and fiscal side

                                                           issues are other concerns compelling

                                                           SBP to opt for a cautious approach. Also,

                                                           it will be prudent to opt for a 50bps cut

                                                           now and see where oil prices settle.

                                                           In favor of rate cut: Sliding inflation,

                               10 = status quo             higher positive real interest, falling

                               7 = 50bps cut               oil prices, approval of IMF fourth tranche,

                               2 = 50-100bps cut           strengthening currency, Sukuk issuance, and

Nov-14        22               1 = 100bps cut              privatization proceeds provide room for a rate cut.

                               Remaining 2 confused        In favour of status quo: postponement of OGDC sell-off,

                               between status cut)         uncertainities quo and 50-100bps over release of IMF

                                                           fourth tranche and strenuous fiscal deficit position

                                                           suggest opting for a status quo is likely.

                                                           Precarious economic indicators including deteriorating

                                                           rupee, pressures on external account, floods, political

                                                           chaos pointed towards a rising

Sep-14        20               All expected status quo   inflation trend. Also, delay in IMF tranche and pressures

                                                           from IMF to maintain a tight monetary policy echoed

                                                           towards a status quo Expectations of high inflation

                                                           ahead of Ramadan, house rent index

Jul-14        25               All expected status quo   revision, electricity tariffs and imposition of new

                                                           taxes coupled with IMFs focus on maintaining tight

                                                           monetary policy.

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