MPS: Still no tightening

The decision is right; but the script misses a few key risks. The policy rate will remain unchanged after the fifth consecutive monetary policy review on Saturday.
The inflation has kept low lately; better than what was expected by economists and the central bank. It clocked at 3.9 percent in the first half and the full-year inflation may remain well below the target of 6 percent. This is encouraging for the doves and we could see that in the November policy review when four out of ten members voted for a 25 basis point cut. And the CPI numbers have come further down since then.
But what has stopped the doves from dominating the January review? The current account deficit (CAD) has become scary of late, and that has eliminated any rationale for rate cut whatsoever. The CAD in December 2017 stood at $1.1 billion (1HFY7: $3.6bn), which is the highest deficit since October 2008. This is despite that fact that oil prices were half from their level couple of years back. That shows that the bonanza of low prices is not enough to sustain balance of payment.
One of the key supports the country had in previous many years was the dollar reimbursement from the US against the war on terror that Pakistan was fighting. That war is now running in name only; and no CSF money has flowed in this fiscal thus far. That has inflated the deficit by $713 million as compared to the same period last year.
The other windfall the economy had for almost a decade was persistent double-digit growth in home remittances. That momentum has now receded owing to a number of reasons including tight money-laundering laws in the West, oil-induced slowdown in the Middle East, and the remittances' high-base effect. Remittances used to cover the trade deficit even in days of higher oil prices; but today, with the increase in non-oil imports amid falling exports, the support is missing.
That is the story on current account balance. Still, the balance of payment had a surplus of $0.2 billion in the first half. Out of the deficit of $3.6 billion, the FDI was $1.1 billion; rest of $2.5 billion was primarily financed by external borrowing. For instance, CSF is replaced by short-term borrowing from China. That is the key difference between US and China; the former sent money for decades as aid; and the latter is giving it as loans.
No wonder, the Chinese money is building infrastructure and a few economic sectors are in expansion mode. If the history is any guide, industrial expansion in Pakistan increases imports more than exports; thus a higher trade deficit. And if the trend continues in years to come; where will the financing come from?
The monetary policy answer to such situation is to have a hawkish stance; and SBP should let the currency to depreciate to discourage imports and boosts exports. But the affinity of PMLN government to a sticky exchange rate is known to all. And this policy probably has deterred growth in foreign investment.
Remember, the investment in sticky exchange rate period of 2002-07 diluted the returns in dollar terms as currency sharply depreciated 2008 onwards. Today, foreign investors are probably reluctant to enter in a market where the REER appreciation is around 20-25 percent. However, SBP had remained silent on currency situation in the last policy review as well.
The other element of concern is the slipping fiscal deficit. The deficit was 1.3 percent of GDP in the first quarter; and with expansionary policy decisions in the second quarter including textile package, all the chances of meeting 3.8 percent of GDP target for the full-year remain elusive.
Then there is a shift in trend in domestic fiscal-financing mix right after the exit of IMF. The government retired its borrowing from commercial banks and reverted to central bank borrowing. The fiscal borrowing from the SBP stands at Rs822 billion in this fiscal year so far as compared to retirement of Rs260 billion in the corresponding period last year.
According to the monetary policy, government retirement of Rs303 billion from commercial banks (against borrowing of Rs672bn in the same period last year) has opened up the space of private credit, which expanded to R296 billion this year so far. That has helped banks' deposits creation, which grew by R250 billion.
But this is a flawed argument as the reduction in fiscal borrowing from commercial banks is matched by the fall in OMO injection by SBP. The growth in private sector credit has marginally picked up to Rs296 billion (from Rs231 billion in the corresponding period last year). The growth in bank deposits is more encouraging as lately the rise in currency in circulation has slowed down.
The bottomline is that the monetary growth is high; and it is primarily due to domestic assets as net foreign assets are in the red. And within domestic assets, the lion's share rests with government borrowing from central bank. Needless to say; that is inflationary in nature and warrants a tight monetary stance going forward.