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Monetary stance accommodative

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You do well; you get rewarded. SBP gave a carrot to the single biggest player in the credit system - the government - by lowering the discount rate by 50 basis points on Saturday. It appears that the government has impressed the central bank with remarkable performance on one front i,e, net retirement of borrowings from the central bank last year; as well as the commitment to continue this trend this year. The commendation comes despite long overdue structural reforms and the persistently high deficit.

This bodes well for anchoring inflationary expectations, according to the Acting SBP Governor. More importantly SBP s model is forecasting FY12 inflation at 11. 5 percent against the government s announced target of 12 percent for the ongoing year and 14 percent for the outgoing year. This gives enough confidence to monetary managers to ease, albeit modestly, the policy rate despite analysts expectations of maintenance of the status quo.

In recent T-bill auctions, trends highlight movement from three months paper to six and twelve months papers which represents expectations of monetary easing going forward. This eases roll-over risk; nonetheless over-reliance on T-bills by the government still poses a risk to interest rate movements in case of adverse external shocks.

Responding to questions, the acting governor explained that inflation is a gap between aggregate demand and aggregate supply. However, we do not see any stimuli to boost aggregate demand while the supply-side remains choked by the energy shortage, uncertain political conditions and a bleak law and order situation. Together these factors are hampering the effectiveness of monetary policy and cannot be addressed by price adjustments alone.

The reason for fall in inflation and its expectations is not the growth of broad money and reserved money; rather its composition, pointed out monetary policy director, Hamza Malik. There is a strong correlation between the NDA to NFA ratio and inflation in Pakistan - higher the ratio, higher the inflation. However, 82 percent of the growth in reserve money; which expanded by 17. 1 percent, emanated from NFA; improving the ratio in favour of low inflation. Substantial retirement of high powered money in the second half of last year also contributed to lowering the NDA contribution in reserve money growth.

The NFA flows were driven by high exports and remittances which helped more than offset the impact of the dwindling foreign aid and soft loans. This improved the foreign currency reserves and lent stability to the exchange rate against the US dollar. It is pertinent to note that 84 percent of the growth in exports and 93 percent of growth in imports can be attributed to rising prices; showing the vulnerability of our external accounts to exogenous factors such as prices of cotton, crude oil and other commodities.

This raises serious concerns on the sustainability of this trend. Eyeing a reversal in prices of cotton and oil, SBP expects imports to grow at twice the pace of exports this year which would lead to an additional burden of 0. 8 percent in the current account deficit as a share of GDP. The financial account has been nose-diving for the past three years and hence offers little support to the BoP - net inflows declined from $5. 3 billion (FY10) to $1. 8 billion (FY11).

The monetary policy statement has warned that urgent efforts are needed to halt the declining investments to GDP ratio to spur growth and employment generation. The government has shifted the onus of borrowing from the central bank to scheduled banks as its borrowings from the latter grew by 75 percent in FY11; contributing a two-thirds of the growth in broad money. During the same period, the piece of pie left to the private sector grew by an insignificant four percent.

Gross capital formation contracted by 3. 1 percent and stood at 13. 4 percent of GDP during FY11; its lowest level since FY74. This decay warrants urgent attention. Supply side bottlenecks like power shortages cannot be controlled by the central bank. Neither can it do much to improve the law and order situation. But surely, SBP can help in improving the investment climate through consistency and independence in the formulation of the monetary and exchange rate policies. However, changing three heads in two years at the helm of this institution will clearly not help this cause.

The other reason for the dwindling private credit is that it is being crowded out by government borrowing and that can be addressed through an out of the box solution such as capping government borrowing from banks and curtailment of the fiscal deficit.

 

 

 

Courtesy: Business Recorder


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