The story of twin circular debts

"The energy sector circular debt issue has not been resolved yet, and the governments borrowings for commodity operations have not seen the expected seasonal retirement in 2QFY10. Since, a large part of these loans has been availed by the TCP and PASSCO, this needs to be settled before it creates another circular debt problem". These words from SBPs first quarterly report see further liquidity shortage and crowding out at the time when private credit demand seems to have revived amid improved lending confidence on part of banks.
By November end, outstanding loans for commodity operations reached Rs335 billion (historically June end average had remained around Rs100 billion). With wheat being the main recipient of commodity financing, the following factors cited by SBP are likely to make repayment even more difficult in coming months.
Higher wheat procurement in FY09 (over 9 million tons versus 7 million target) which supplemented the imported stock from preceding year with inadequate storage facilities might not only cause wastage but also reduce prices. The problem could exacerbate with lower international prices that might cause inward smuggling of cheaper wheat in domestic market, in the absence of any incentive for exporting domestic commodity. The government may suffer losses in case of rains and lower off-take of domestic stocks.
These issues might not allow TCP and PASSCO to repay their loans - potentially leading up to increased level of domestic liquidity shortage. Not to mention, the energy circular debt that had reduced to Rs85 billion in September 2009 jumped once again to Rs250 billion plus by December. And the banks reluctance to finance it, having maximized their loan limits to energy sector, the two circular debts emanating from public sector entities are likely to cause some crowding out.
By the first quarter of this fiscal year, the private sector credit demand was virtually absent with most banks reluctant to lend. But, in the last quarter with some revival in domestic economy, this trend visibly changed - private sector credit rose by Rs212 billion (7%) in Oct-Dec 09 compared with a net retirement of Rs30 billion (1%) in the preceding quarter.
With likely fall in tax-to-GDP from a meager 9.8 percent owing to just 0.6 percent, year-on-year growth in federal taxes during Jul-Nov and diminishing hopes of FoDP pledges amid doubts over Coalition Support Fund, a reduction in development expenditure is as imminent as fiscal slippage is inevitable.
Worrisomely, the government will rely more and more on commercial banks and other domestic sources to plug its fiscal gap.
"Continued excessive fiscal needs can have adverse implications for market liquidity, interest rates and credit to private sector, which in turn will limit the central banks ability to further reduce the policy rate. The continued fiscal stimulus could also complement an expected rise in imported inflation, raising the risk of resurgence in domestic prices" noted the central bank. This essentially means that on January 30, its going to be tricky for the central bank to make a call on its policy rate.
The latest headline inflation numbers saw a fall of 0.5 percent month-on-month, with average first half inflation falling to 10.31 percent compared with 24.4 percent in the year-ago period amid some signs of credit demand by the private sector may create hopes for a 50-100 bps cut.
But, the core inflation, which after declining for last ten months by 8.3 percent to 10.6 percent in November rose by 10 bps last month, may persuade SBP to contemplate over status quo. And with rupee sliding down with crude heading north, resurgence in imported inflation cannot be ruled out. Last but not the least, the need to incentivise domestic saving for fiscal financing, will keep pressure on money managers to keep the policy rate unchanged.