MPC: wait and see

There are clear signs of current account slippages. This comes in tandem with economic recovery in Pakistan. A better fiscal year (2020-21) - in terms of growth and tamed current account deficit - is now over. Now the key is to manage the delicate balance. That is, to maintain the growth momentum and at the same time, not let the bubble grow. It is not an easy task. The first line of defence to counter external account slippages is exchange rate. It is already in action. The currency may slip a bit further and the monetary policy committee may wait and see its impact on current account and overall demand. Expect no change in interest rates on Tuesday's policy review.

The unfortunate tradition of external account boom and bust cycle, and its proximity to election cycle is well established. Previous governments that had attempted to ride the boom cycle wave prior to elections failed to win elections, nonetheless. PTI should take a leaf out of history and should not repeat others' mistakes. There are signs of a different approach this time in the form of a flexible exchange rate. That must remain in place.

In many economies, exchange rate is a tool to counter ballooning current account deficit. That is to manage the imported demand to curb imports and boost exports. If the demand is emanating from domestic economy (or economy at large), interest rates are best to be used. In simple words, if demand side inflationary pressures are visible, increase in interest rates is the best policy tool.

In Pakistan, exchange rate was never used to curb demand until it turns into a full-blown crisis. Invariably, a combination of sharp exchange rate and interest rate adjustments were used to curb external and internal imbalances. Such policies are not good as overall economic slowdown causes considerable damage to businesses and average household purchasing power parity. That is why it is imperative to curb the current account deficit before it turns into a crisis. That is why recent exchange rate movement is healthy.

The question is what is an ideal level of current account deficit is and how to assess that its slippage is not due to domestic demand boost. Well, in an economy like Pakistan's having (up to) 2-2.5 percent of GDP deficit is acceptable only if there are debt and investment sources to fund it. In recent years Pakistan has seen an active debate on good and bad current account deficit/surplus. At that time, excessive tightening was the need because the deficit in the yesteryears was too high and virtually all the SBP reserves were used to finance it. The country had to go to the IMF and had no choice but to create space for reserve building by muting demand. That is why running current account surplus for a few quarters was appreciated. Now the reserves are building and there are avenues to finance moderate deficit. Let it run this way with small adjustments. The foremost economic consideration should be to build and sustain an economic momentum.

Having said that, $1.6 billion deficit in a month or $2.3 billion (4.6% of GDP) deficit in the last two months is raising eyebrows. An average monthly run rate of $500-700 million current account deficit should be the acceptable range. In June, there were some one offs - but barring that, around $1 billion per month is a little too high a number. That needs to be kept in check. That is why currency market is under pressure. There are some demand-supply factors too as payments are higher these days (due to lingered dividend payments etc). But higher oil and other commodity prices are putting pressure on the currency too.

In the next few months, any impact of currency depreciation on current account will be visible. If CAD persists at higher levels despite depreciation, then interest rate adjustment may be warranted. Some hawks may argue in the upcoming monetary policy too for tightening, but inflationary trends suggest otherwise. Globally, big central bankers are saying that the rising inflation is temporary. In Pakistan, recent spurt in inflation and partially current account deficit is due to global supply chain disruptions. Federal government is compromising on revenue by not passing on the impact of oil prices to consumers, but the import bill is reflecting the higher prices. If pressures are indeed transitory, prices will come down and that would curb deficits and tame inflation in Pakistan too. If that happens, currency may rebound. Otherwise, interest rates must increase sooner or later to curb inflation and deficits.

Then there are elements of domestic demand that need to be assessed. The output gap is still negative. This means economic capacity is outpacing the demand, and inflation is supply side. But with federal and provincial governments raising wages and hiking minimum wage, the private sector may follow. Let's see if this creates wage-price spiral. If so, hawks may come to dominate in a few months.

The other element is, of course, of fiscal policy. On paper it is expansionary - procyclical as economy is expanding too. Principally, prudent fiscal policy should be countercyclical to have a balancing act. If the policy in essence is expansionary, contractionary monetary policy is warranted. However, federal fiscal space is limited and with possible shortfall in revenues (mainly in non-tax such as petroleum levy), actual spending may not be highly expansionary.

Monetary Policy Committee (MPC) may like to wait and see how fiscal policy shapes up in the first quarter. MPC may also wait to see the direction of international commodity prices. MPC may wait to see the impact of exchange rate movement and possible opening of travel on current account. It may wait to see the wage-price spiral and output gap. Similarly, the future direction of relationship with the IMF will also be an important indicator, as it is imperative for the monetary policy in the short to medium term. Keeping these factors in view - and the fourth Covid wave in Pakistan (and emergence of the delta variant) - it is best to keep rates unchanged and let the exchange rate play its role.

However, adjusting exchange rate too much can bring imported inflation home and may force SBP to tighten aggressively in coming quarters. Hence, it is imperative to strike a delicate balance between exchange rate and interest rates. There is always a trade-off. Exchange rate is relatively market based and market reacts in accordance with interest rates and inflation differential. If interest rates are kept unchanged for too long, the time may come to go for sudden hikes due to inflation coming in from excessive exchange rate adjustments. The volatility in interest rates proved to be a killer in the past and SBP should avoid it. Keeping this in view, a token increase in rates before the end of calendar year would be a prudent approach to monetary policymaking.

Copyright Business Recorder, 2021