The policy rate is maintained at 7 percent. Forward guidance is of accommodating monetary policy; but the degree of accommodation can be altered. Given the current account vulnerabilities and possible fiscal slippages from budgeted number, SBP may reduce the degree of accommodation in the next monetary policy. SBP may be cautious in its actions as COVID’s fourth wave is emerging. Also, the policy would be well spelled out and be forthcoming to maintain the growing business confidence, which is at multi-year high.
The monetary policy is not proactive (or hawkish) due to risks related to COVID; and it does not want to disturb the growth momentum. The catch is to strike a delicate balance between controlling current account slippage and excessive currency depreciation; and if any signs of such to occur, a slight adjustment in the policy rate could be the case. The first target is to see things in September. The forward guidance keeps the possibility of rate hike, and there are chances of no change.
The question is what indicators market needs to see. One is the current account. SBP is confident that June number was one-off. If the deficit on average stands at $500-800 million per month (annualized 2-3 % of GDP), SBP may be comfortable with it. The next question is whether the currency levels today can withstand this deficit. Well, the currency has shown some recovery in the last two trading sessions, and seeing the planned external financing and growing RDA, PKR/USD may hover around current levels.
However, if it starts depreciating then a possible inflationary consequence can emerge where SBP can probably use interest rates to stabilize currency and external accounts. The other important variable is building of reserves. There are bounties coming from the IMF and other planned sources. There is an open tab of Euro Bond and Sukuk. RDA is building – soon to reach $2 billion.
Some may say that its debt-built reserves and earlier these were discouraged. Well, what should raise eyebrows is falling reserves. Pakistan needs current account financing to continue growth momentum and to build business confidence. Seeing these, they continue to reinvest the profits in future expansion. Observing the domestic investors rush of blood, foreigners might jump in, and joint ventures could take place and FDI could pour in. The first injection is usually of debt. The investors see the strength of balance sheet that comes from how fat the reserves pie is.
In a nutshell, two factors are important on current account. One is the reserves level and the other is currency. SBP feels that 2-3 percent is manageable. The other element is inflation as keeping negative rates can create asset bubbles and boost artificial demand. Within inflation, the elements to note are demand driven. One is core. So far, its fine. An important indicator is wage-price spiral. There are no signs of it yet. If this start emerging, SBP may have to raise rates. The other is output gap. It is almost in balance and with businesses in expansionary phase; it may not turn positive with growth in demand. As far as it is near zero or negative, it may not push SBP to increase rates.
Then there are fiscal factors. On paper, this budget is contractionary with primary fiscal deficit to shrink. That is countercyclical on paper as economy is in expansionary phase. This can gel well with contrasting accommodating monetary policy. However, if the fiscal deficit slips, the monetary policy degree of accommodation should adjust accordingly. It all depends on how much revenues – tax and non-tax, the government will generate. There are serious risks to non-tax revenues -mainly petroleum levy. At current oil prices, there will be a big gap if domestic petroleum prices are not increased. IMF may want this if government is short on primary balance target. This links to global commodity prices hike risk. It has implication on fiscal and external accounts, and on inflation. There could be pressure on currency too. If these persist at high levels, 50 bps hike in this calendar year is on the cards.