A prudent monetary policy approach

Monetary Policy Committee (MPC) of the State Bank, in its meeting held on 24th November, 2017, opted once again to leave the policy rate unchanged at 5.75 percent for the next two months. The decision was mainly based on rising economic activities, lower inflation and a manageable current account deficit. According to the Monetary Policy Statement (MPS), economic activity was strong as "corroborated by broad-based pickup in industrial output, gains in factors supporting production of major crops, and growth in private sector credit. This implies that the prospects of achieving 6.0 percent target of real GDP growth continue to be strong." Inflation expectations show that overall inflation was expected to remain well below the target of 6.0 percent. On the fiscal front, a healthy growth of 22.0 percent in tax revenues collected by FBR during July-September, 2017 compared to the modest rise of 4.5 percent in the corresponding period of last year was a welcome development. However, near-term balance of payments challenges continue to persist though visible improvements in export growth, notable increase in FDI and expected other financial inflows would help to contain the pressures.
LSM growth of 8.4 percent during the first quarter of FY18 compared to 1.8 percent in the corresponding period of last year has surpassed the earlier expectations and this was due to improved security conditions and better power supply, transformation of fixed investment into enhancement of productive capacity, lower inflation and stable interest rates. "Barring any extreme events, agriculture sector is expected to perform better for the second consecutive year." Demand for services is also expected to rise, given its inter-connectivity with the other two main sectors. CPI inflation averaged 3.5 percent during July-October, 2017, well below the annual inflation target. Higher international prices with their pass-through effect to domestic petroleum prices and the imposition of RD on non-essential import items was expected to increase inflation in the coming months but overall inflation was still expected to fall in the range of 4.5 - 5.5 percent for the whole year. Coming to the monetary field, there was a visible change in the pattern of government borrowing for budgetary financing. "Instead of relying heavily on Central Banking financing like last year, the government is securing funds both from SBP and scheduled banks." Credit to the private sector on YoY basis grew by Rs 814.9 billion (18.5 percent) in October, 2017 as compared to Rs 436.4 billion (11.0 percent) in the corresponding period last year.
Current Account (CA) deficit had widened to dollar 5.0 billion during July-October, 2017 as compared to dollar 2.3 billion in the corresponding period of last year. Pakistan's exports showed an improvement and remittances had recorded a modest growth but the impact of these positive developments was more than offset by growth in imports. SBP's foreign exchange reserves stood at dollar 13.5 billion on 17th November, 2017, down from dollar 16.1 billion at end June, 2017. Going forward, progress on the CPEC-related projects and other official proceeds could be instrumental in managing the overall deficit.
Although the SBP seems to have made a reasonably good case to justify an unchanged monetary policy, a positive spin seems to have been given to most of the relevant indicators to arrive at a pre-conceived decision. MPS has given a lot of emphasis to higher growth likely to be registered this year but ignored certain factors which may depress its prospects. Shortage of irrigation water, smog in Punjab and price problems with wheat and sugar may affect agriculture sector adversely while dismal saving rate in the economy and political uncertainty could dampen the prospects of industrial sector. A poor outcome in these two sectors could retard the growth prospects of the services sector because of inter-connectivity. However, it appears certain that even if a growth rate of 6.0 percent or so is registered this year, it is not going to be sustainable if saving rate is not increased to 20 percent or so which looks impossible. So far as credit expansion in the private sector is concerned, it usually enhances demand in the initial stages which could cause inflationary pressures in economy. The MPS has cited the securing of funds both from SBP and scheduled banks as a positive development but the State Bank of Pakistan could easily change such a mode of financing by its action or through a policy measure. Greater access of the government to scheduled banks' financing is, nonetheless, not so desirable as it could slow down the flow of credit to the private sector. The central bank this time has avoided mentioning the overall fiscal deficit except to say that revenues collected by the FBR were higher and forgotten any reference to the expenditure side. Reference has also not been made to the rapidly rising circular debt which could widen the budget deficit later on and also pose other problems.
The overlooking of a developing crisis in the external sector in the MPS is very strange, to say the least. The SBP thinks that the introduction of regulatory duties on non-essential imports is expected to help curb some growth in imports and the progress on the CPEC-related projects and other official proceeds will be instrumental in managing the overall balance of payments deficit. In our view, this is wishful thinking. Imports are rising so rapidly that the present increase in exports, foreign remittances and direct foreign investment is woefully insufficient to reduce or contain the overall current account deficit. It is surprising that the SBP is not giving sufficient attention and weight to the rapidly widening C/A deficit and declining reserves which had already fallen by dollar 2.6 billion during a short period of four and half months. Governor SBP, is part of a government delegation that top government functionaries has already gone abroad for road shows to float dollar 2 billion Eurobond and Sukuk to cover the widening gap in the external sector but such action would only increase the stock of external liabilities and that too at a great cost to the country. A balance of payments (BoP) crisis is unfolding before our eyes but neither the government nor the SBP is trying to stem the tide on a sustainable basis. The State Bank, in our view, could at least help a little bit by raising the policy rate to 6.0 percent to slow down the dollarisation of the economy and reduce pressure on the rupee. Such an action would also have increased the flow of remittances somewhat by enabling the expatriates to earn better returns on their financial investments in rupee terms.