MPS in unprecedented times

Seventy-five bps it is, in line with expectations of BR Research. The analyst community was also expecting a cut in the same range; however, fund managers appeared more upbeat. Analysts have deeper eye on economy while fund managers are keen on stock market impact.

However, no rate cut can subside the bear run that has ensued since the outbreak of the global epidemic. Looking at US-Fed, even zero rates are not working, and the US central bank does not have much else in ammunition. Fortunately, SBP has a lot of room to adjust in uncertain times. If things keep on going south, an emergency meeting before the May policy meeting cannot be ruled out.

The key factor in determination of monetary policy for Pakistan is ensuring stability of external account. There appears to be a lot of reliance on current account savings, domestic foreign currency conversion and portfolio investment (hot money). Beginning last week, the hot money flows have become uncertain. The government was looking to issue Euro bonds; but that is no longer feasible till COVID-19 aftershocks persist. The economic easing hinges upon buildup of reserves. Government should immediately approach IMF for its share in the recently created ‘concessionary funding pool’ pie.

If the recent volatility is taken out of equation, external account recovery has been relatively quick. Underlying economic fundamentals are intact; yet information remains scarce which is creating uncertainty. Times are fluid, with more information, further policy actions may be taken. SBP is introducing concessionary credit facility for long term investment (on 7 percent fixed borrowing rate for 10 years) for all industrial units (ex. power) and has offered short term facility to hospitals and medical centers to import equipment to combat the spread. More out of the box actions could be taken in days to come. SBP is working on providing working capital relief for businesses affected by demand suppression or supply chain disruption. In case of exporters’ facing liquidity shortage, refinance facility at even lower rates is already present.

The other important element is inflation. SBP’s stated policy is to maintain real interest rates in the vicinity of 1-2% based on forward looking inflation. Inflation outlook has improved relative to the last policy review. Even prior to COVID-led demand suppression and commodity price decline, inflation was expected to tame during Mar-20. SBP has not yet provided its next year (FY21) inflation target, which may fall in the band of 8-10 percent. SBP noted that real interest rates are appropriate on medium term inflation target of 5-7 percent. This means SBP is targeting medium term inflation and will remain hawkish till signs of the same are not in sight.

Having said that, keeping real interest rates in the band of 1-2 percent means that policy rate may climb further down in upcoming reviews. Rate cuts could be aggressive once inflation is finally in single digit. That time is not too far. 100-150 bps cut in next 2-3 policy reviews cannot be ruled out. It’s important to see external account trajectory in months to come.

Market was expecting higher cut due to global spree of slashing rates by central banks. One may introspect on the possible benefits of rate cut to counter recessionary tailwinds resulting from a global pandemic. It’s clearly not working in stabilizing financial markets. No rate cut can regenerate the demand for consumption such as visits to malls and restaurants when public faces risks of a highly transmissible disease. No stimulus can make people plan for tourism in coming months. The fear for life and limb has confined people to their homes. Only medical response can address these. Central banks surely are not in the race of finding vaccine of COVID-19.

The other element is risk of real economic slowdown for economies which are dependent on exports and tourism. These are immediately impacted. Pakistan is a consumption based economy where domestic production is dependent upon raw material imports. The impact of global supply disruption is lower on Pakistan as compared to many other economies. Hence policy response has to be similar.

On the fiscal side, some pressures continue to persist. Low oil prices give some room in filling the gap in tax and other revenue collection. PSDP allocation has been increased recently. LSM has shown signs of nascent recovery as well. These two factors are good for growth, but benefits could well be eaten out by recent slowdown. In a nutshell, these development support rate cut going forward.

But the concluding remarks in the MPS could bring adversity for conventional commercial banks. SBP has decided to make the interest rate corridor symmetric. This would mean that both floor and ceiling are 100 bps apart from policy rate. Earlier, floor was lower by 150bps and ceiling was 50 bps. The minimum deposit rate (MDR) for banks is at floor minus 50. Till today, floor was 11.75 percent and now it would be 11.50 percent. The MDR will be reduced from 11.25 to 11.0 percent. This will squeeze banks spread by 50 bps. In days of stress, banks should be provided regulatory support. Instead, this measure might cause disruption in the sector in the short term. It remains to be seen whether the central bank will hold its ground on MDR or relent to pressure from the bankers in its meeting with their presidents today.