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The recent meeting of the Monetary Policy Committee (MPC) of the SBP (State Bank of Pakistan) has led to the decision to raise the policy rate by 100 basis points to 16%. It is now at its highest ever level. In the previous meeting in early October, it had been retained at 15%.

Reading the Monetary Policy Statement leads to the view that the Committee has changed its perceptions more to the downside on the state of the economy and emerging trends. This is perhaps best illustrated by the statement that ‘inflationary pressures have proven to be stronger and more persistent than expected.’ The headline rate of inflation increased sharply in October to 26.6%.

Consequently, the MPC has upgraded the projected average FY23 rate of inflation to 21%-23%. Earlier, the projection had been 18%-20%. This is attributed to the increase in electricity prices, acceleration in food prices due to flood crop damage and even higher core inflation.

However, one important factor contributing to higher inflation has not been highlighted. This is the quantum depreciation in the value of the rupee with respect to the US$ of almost 29% between October 2021 and October 2022. During this period, foreign exchange reserves have plummeted from $17.2 billion to $8.9 billion, a big drop of 48%.

The reserves as of the 25th of November now stand at the even lower level of $7.5 billion. There is the risk that they could fall even further after the payment on maturity of the $1 billion Sukuk Bond in the first week of December, despite the $500 million received recently from the AIIB (Asian Infrastructure Investment Bank).

The exchange rate is highly responsive to the level of foreign exchange reserves, as measured by the import cover. They now stand at close to only 1.2 months. Historically, it has been observed that when reserves drop to such a low level, then the rupee begins to fall in an accelerated fashion. If this happens then there could be even further depreciation of the exchange rate in coming weeks. For every 1 percentage point drop in the value of the rupee there is likely to be a 0.2 percentage point increase in the rate of inflation. Therefore, it will not be surprising if the average rate of headline inflation approaches the higher average of 23%-25% in 2022-23.

The other crucial and related magnitude is the size of the current account deficit. The MPC has noted with some sense of relief that a sharp decline in imports has led to a significant moderation in the size of the current account deficit.

There is a problem here. If we take as an example the petroleum group imports, the largest group of imports, there has been a colossal drop in the volume of imports of 30%. Domestic consumption of petroleum imports is down by 22% in the first quarter of 2022-23. Is the larger drop a reflection of a lack of financing with importing agencies? This portends a shortage of petroleum products.

Similarly, there is a drop in other import volumes, except for food imports. Imports of transport vehicles, electrical machinery, telecom equipment, textile inputs and the metal group are down by 48%, 26%, 54%, 17% and 30%, respectively. Such colossal declines may actually reflect administrative controls and deferment of LCs. This is an arbitrary device for restricting imports, with deleterious consequences on domestic production in different sectors.

Surely, the policy ought to have been to manage imports through a market-determined value of the exchange rate. The talk of raising the value of the rupee to below Rs 200 per $ has been counterproductive and led to a massive widening of the gap between the open market and inter-bank rates. Consequently, remittances have started falling sharply. Clearly, the SBP is not fully exercising its newfound autonomy following the fundamental amendments in the SBP Act last year.

The Monetary Policy Statement further rightly highlights that despite the objective of fiscal consolidation in 2022-23, there has been a marked deterioration in the fiscal outcome in the first quarter of the year. The fiscal deficit has increased from 0.7% to 1% of the GDP and the primary surplus has fallen from 0.3% to 0.2% of the GDP. The deterioration is apparently due to higher debt servicing and lower non-tax revenues, especially from the petroleum levy.

The question that arises relates to the outlook for the budgetary position in the remaining three quarters of 2022-23. The first area of concern continues to be debt servicing. There is now the prospect, first, that the budget deficit in 2022-23 will be significantly above the very low target level of 4.9% of the GDP, thereby necessitating more borrowing. Second, the cost of debt servicing will be higher due also to the hike in the policy rate.

Third, what has not been highlighted is that in the first quarter of the year, over 96% of the deficit financing has been through domestic bank borrowing. This is a strong indicator of the limited access to external borrowing due to the big loss of international creditworthiness of Pakistan.

The year had started with 62% target of domestic financing of the deficit. However, now it appears that not only will the deficit be larger but also the contribution of domestic borrowing will be much greater by possibly as much as Rs 1800 billion. In effect, the impact on expansion of money supply could be much larger. This is one source of inflation in coming months which apparently the SBP has not allowed for. Further, the cost-push impact of the impending jump in the electricity tariff and more than doubling of the gas price has also to be allowed for.

These additional factors impacting on inflation have to be taken into account in projections by the MPC. The recent statement is more focused on the downside of the economy. However, there is still need for accounting for other factors that are impacting negatively on the economy.

Copyright Business Recorder, 2022

Dr Hafiz A Pasha

The writer is Professor Emeritus at BNU and former Federal Minister

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