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State Bank of Pakistan (SBP) has made a surprise and aggressive move by increasing the policy rate by 150bps (basis points) to 8.75 percent. The message is loud and clear: the central bank is out of the “gradual and measured change” territory. However, the end goal is unchanged, i.e., to reach mildly positive real rates. In the new world, SBP is building expectations to take ‘measured’ steps (gradual is out of the equation) towards this end. The reason for change at heart is shift of risks from growth to inflation and external account. This expedites the tightening. But don’t expect similar steps in the upcoming policy. Expect another increase of 75-100 bps in the next two reviews before the tightening cycle concludes.

SBP still thinks that economic growth in FY22 will remain high; but this cannot be left unleashed to cause further instability in the external account or bring demand driven and imported (due to currency depreciation) inflation. That is why hawks have completely overshadowed doves. The growing current account deficit is giving teeth to hawks. Although policy is to target inflation, the key number to carefully monitor is current account deficit and any slowdown in it can calm hawks.

The stated end goal is to achieve mildly positive real rates on forward looking inflation. SBP has not (so far) changed the inflation outlook of 7-9 percent for FY22. However, it has mentioned that there are upside risks to the forecast. Market is expecting average inflation in the range of 9.5-10.5 percent in CY22 (Jan22-Dec22). PIDE predicts inflation in the range of 10-10.5 percent and 11-11.5 percent in 2HFY22.

However, SBP might be a little conservative in its approach. Since the change last week was front-loaded, the economic model predictions may get a bit milder. It is likely that SBP may change its inflation forecast to 9-10 percent for FY22 and a similar number for the next twelve months. The policy rate may increase between 75-100 bps in the next 2 reviews to end the tightening cycle. The actual outcome could be hinged upon the inflation numbers in the next 2-3 months, and current account position.

That is the story of inflation forecast and SBP’s stated view on it. But not everything is being said. The real concern in hand is growing external account worries, and in turn its impact on the currency. Pakistan’s major concern is external account (including current account). The tightening is an attempt to ease the pressure. And the hawkish stance at the SBP is perhaps aimed at sending a signal to the IMF (International Monetary Fund) on SBP’s commitments to keep demand in check.

In a market-based exchange rate regime, there is always a trade-off between exchange rate and interest rates – especially in an economy with low reserves and high current account deficit. SBP is trying to curtail the currency deprecation; but nothing is working. Earlier, the news of Saudi Arabia’s deposits and deferred oil facility brought some stability – but was short lived. Then SBP all of a sudden increased the cash reserves requirements (CRR) for commercial banks by 1 percent to curb economic demand. But this proved insufficient to arrest the currency slide.

Seeing the recent weekly inflation numbers and the way current account is slipping, SBP decided to tackle the uncertainties through front-loading. Like the way it did in 2019. The immediate worry is to bring stability in the currency market and that is important for inflation targeting. With this higher increase, and IMF review finalization (expected in the coming week), the currency may stabilize, and it could appreciate by a few percentage points.

Many thought that SBP could have increased the rates mildly this time and could have communicated through forward guidance for a similar (or higher) increase next time. But SBP sought to be ahead of the curve. The market rates have already increased by over 100 bps since the last increase. And on Friday, seeing the current account numbers, before the policy rate decision, market rates shot up further.

The secondary market T-Bill and 6M-KIBOR were 9.12 percent and 9.16 percent as of Friday’s close- before the policy announcement. These should be around 9.25 percent at policy rate of 8.75 percent. This means the market has already incorporated the increase. Seeing this, the criticism of business community on higher increase is misplaced. Yes, had SBP have a lower increase, market rates could have come down. But then the currency depreciation would have continued. It’s a trade-off.

The key to note is that the deposits rates are linked to policy rate – 50 bps below the floor. These change with policy rate. Borrower is already paying a premium. Now depositors shall get 175 bps higher rate. This may attract deposits in Pak Rupee. SBP expects dollarization to end due to this front-loading – as was the case in 2019. Plus, this could entice the hot money to flow in too. SBP strike is for better external flows to build reserves and to arrest the drip-by-drip currency depreciation.

Copyright Business Recorder, 2021

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Ali Khizar

Ali Khizar is the Head of Research at Business Recorder

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