The State Bank of Pakistan appears to be trying to atone for its past sins. It remained entirely passive when the rupee appreciated recently by 7 percent in eight days. It ought to have intervened to stabilize the rupee by buying dollars. This would have enabled a more orderly transition following the “gift” of $1.5 billion from “friendly” countries. The IMF press statement recently from Washington has clearly highlighted this failure.
By keeping the policy rate unchanged, the SBP may be signaling one of two things. Either it expects that the exchange rate will remain overvalued and sooner or later exports will suffer and imports will rise, exacerbating the current account deficit in the balance-of-payment and putting pressure on foreign exchange reserves. In fact, the real effective exchange rate shows an appreciation of 10 percent since end June 2013, although the reserves, even post-gift, have fallen by 25 percent and can finance only five weeks of imports.
Alternatively, the SBP may be worried about the lack of sustainability of the exchange rate if it adopts a softer monetary policy stance by bringing down the policy rate. The risk is that aggregate demand will remain high and jeopardize the balance-of-payments position. In fact, the open market rate has shown a tendency to rise once again, implying that the market sees the currency as being overvalued. Will the SBP now start selling dollars?
It is not surprising that exporters have reacted sharply. Their competitiveness and incomes have been severely hit and they were looking forward to some compensation via a drop in the interest rate on export finance.
Beyond the compulsion of preventing a hemorrhaging of the underlying balance-of-payments due to the currently-overvalued exchange rate, there are also some fiscal compulsions which probably motivated the SBP to keep the policy rate unchanged.
The first compulsion is to bring down the borrowing of the “fiscal authority” from the SBP of Rs501 billion as of March 7, 2014 to Rs222 billion by the end of the month, as per the IMF performance criteria for the third quarter.
The second compulsion is to shift from excessive short-term borrowing (by T-bills) to longer term borrowing (by PIBs). Some success has been achieved in the recent auctions, but with high yields approaching 13 percent per annum, equivalent to real returns of almost 5 percent, the realization of these objectives could be seriously jeopardized if interest rates are brought down.
It all hinges on “inflationary expectations”. These can change favorably only if, first, the newly appreciated exchange rate remains stable and, second, this is accompanied by significant reduction in administered prices of electricity and petroleum products. It is still too early to say if these events will happen.
Any improvement in inflationary expectations can then be reflected in lower interest rates, including the policy rate. The next monetary policy statement ought to be based on a visible fall in the rate of inflation. Meanwhile, the SBP has tried to cover up on its past mistakes by following the sensible policy of keeping the policy rate unchanged. This will, no doubt, appease somewhat the IMF in its forthcoming third quarterly review of the programme with Pakistan.
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