Daily The Business

Policy rate up by 50 bps to 10.75 percent

Jahangir Hayat

LAHORE: The State Bank of Pakistan Monetary Policy Committee (MPC)
Friday decided to increase the policy rate by 50 bps to 10.75 percent
effective from 1st April 2019.
Economic data released since the last Monetary Policy Committee (MPC)
meeting in January 2019 indicates thatthe impact of stabilization
measures continues to unfold.In particular, the current account
deficit recorded a sizeable contraction during the first two months of
2019,which, together with bi-lateral inflows, helped ease pressures on
SBP’s foreign exchange reserves. These developments on the external
front have improved stability in the financial markets, reduced
uncertainty and improved businesses confidence, as reflected in
various surveys. Nonetheless, despite narrowing, the current account
deficit remains high, fiscal consolidation is slower than anticipated,
and core inflation continues to rise.

Average headline CPI inflation reached 6.5 percent in Jul-Feb FY19
compared to 3.8 percent recorded in the same period last year.
Meanwhile, YoY CPI inflation has risen considerably to 7.2 percent in
January 2019 and further to 8.2 percent in February 2019- the highest
YoY increase in inflation since June 2014. These pressures on headline
inflation are explained by adjustments in the administered prices of
electricity and gas, significant increase in perishable food prices,
and the continued unfolding impact of exchange rate depreciation.
Core inflation maintained its 13-month upward trajectory accelerating
to 8.8 percent in February 2019 from 5.2 percent a year
earlier.Further, rising input costs on the back of higher energy
prices and the lagged impact of exchange rate depreciation are likely
to maintain upward pressure on inflation despite a moderation in
aggregate demand due to a proactive monetary management. As a result,
headline CPI inflation is projected to fall in the range of 6.5 to 7.5
percent for FY19.

Amidst the efforts to curtail inflationary pressures and reduce the
otherwise widening macroeconomic imbalances, domestic economic
activity experienced the brunt of the stabilization measures
implemented thus far. In particular, Large-scale Manufacturing (LSM)
declined by 2.3 percent during Jul-Jan FY19 against 7.2 percent growth
recorded in the same period last year.  The latest available estimates
of major crops also depict a lackluster performance by the agriculture
sector. The slowdown in commodity producing sectors has downside
implications for growth in services sector as well. Similarly, a
deceleration in consumer demand and capital investments, reflected
through a cut in development spending and deceleration in credit for
fixed investments, indicates a moderation in domestic demand. In this
backdrop, the real GDP growth is projected to bearound 3.5 percent in

Owing to stabilization measures, the current account deficit narrowed
to US$ 8.8 billion in Jul-Feb FY19 compared to a deficit of US$ 11.4
billion during the same period last year- a fall of 22.6 percent. This
includes a notable pace of retrenchment of the current account deficit
by 59.9 percent during the first two months of 2019 over the same
period last year.  This reduction in the external balancewasmainly
driven by a 29.7 percent decline in the trade deficit in goods and
services as well as a strong growth in remittances. The reduction in
the trade deficit is in large part driven by import compression- this
decline would have been even more pronounced if not for a rise in oil
prices.  Exports, in dollar value, during this period remained flat,
however in terms of quantum there has been a notable improvement.
Though still posing a significant challenge in term of its financing,
the narrowing of the current account deficit has translated into some
stability in the foreign exchange market.

With an improvement in the external balance as well as an increase in
bilateral official inflows, SBP’s foreign exchange reserves gradually
recovered to US$ 10.7 billion on 25th March 2019. While the reserves
are still below the standard adequacy levels (equal to three months of
imports cover), the recent improvement on the external front has
nevertheless improved business confidence. This is captured in the
recent wave of IBA-SBP surveys of large number of firms in industry
and services sectors. Having said that, the share of private financial
flows need to increase on sustainable basis to achieve medium-to-long
term stability in the country’s external accounts. Similarly, as
enunciated in previous statements, concerted structural reforms are
required to reduce the trade deficit by improving productivity and
competitiveness of the export-oriented sectors.

The fiscal deficit for HI-FY19 was higher at 2.7 percent of GDP when
compared with 2.3 percent for the same period last year.  In view of
the shortfalls in revenue collections and escalating security-related
expenditures it is most likely that the target for the fiscal deficit
in FY19would be breached. So far, a significant portion of the fiscal
deficit was financed through borrowings from SBP, which if continued,
will not only complicate the transmission of monetary policy but also
dilute its impact and prolong the ongoing consolidation efforts.

In absolute terms, the government borrowed Rs3.3 trillion from SBP and
retired Rs2.2 trillion of its borrowing from scheduled banks (on cash
basis)during 1st Jul – 15th Mar, FY19. This in turn, facilitated the
banks to meet private sector credit demand that increased by 9.2
percent without putting pressures on the market interest rates. Much
of the increase in credit demand was for working capital due to higher
input prices and capacity expansions in the power and construction
allied industries. Overall, money supply (M2) grew by 3.6 percent
during 1st Jul – 15th Mar, FY19 against a 2.4 percent increase in the
same period last year. This growth in M2 was solely driven by
expansion in net domestic assets, as net foreign assets declined.

Taking into account the above developments and the evolving
macroeconomic situation, the MPC noted that sustainable growth and
overall macroeconomic stability requires further policy measures as:
(i) underlying inflationary pressures continue; (ii) the fiscal
deficit is elevated, and (iii)despite an improvement,the current
account deficit is still high.

In this backdrop and after detailed deliberations, the MPC decided to
increase the policy rate by 50 bps to 10.75 percent effective from 1st
April 2019.

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