Propelled by the contributions from the three major sectors, viz. agriculture, industry and services, the growth rate rose to a 20-year high of 8.4 percent during FY05 as against the target of 6.6 percent.
The exceptional growth, according to the State Bank, was due to a combination of strong domestic demand, good luck in terms of timely winter rains, continuity of policies and a robust financial sector. However, performance in other areas of the economy was not impressive.
The national savings deteriorated for the second consecutive year, registering a 4.5 percent fall in FY05, after witnessing a deceleration in growth to 3.2 percent last year. As a result, national savings dropped from the FY03 peak of 20.8 percent of GDP to 15.1 percent of GDP in FY05.
Inflationary pressures that were visible in the economy since H2-FY04 strengthened significantly, with the annualised CPI inflation rising to 9.3 percent - the highest level since 1997. The CBR achieved its revenue target for the third successive year but expenditures exceeded the target substantially, pushing the overall budgetary deficit to 3.3 percent of GDP which was higher than the target of 3.2 percent and a deficit of 3.0 percent of GDP realised in FY04.
Monetary policy witnessed an important transition during FY05, switching from a broadly accommodative stance to an aggressive tightening in the second half of the fiscal year. The reasons for reluctance of the State Bank to tighten monetary policy earlier have also been explained in the report.
On the external sector, trade deficit jumped to a record level of $4.5 billion as against $1.6 billion during the preceding year. The current account registered a deficit of $1.6 billion as against the surplus of $1.8 billion last year.
However, the deficit was partly offset by significant capital flows like one-off inflows through privatisation and floatation of sovereign debt. External debt ratios, nonetheless, improved due mainly to larger increase in nominal growth rate, enhancing the country's capacity to carry debt and reducing its vulnerability to external shocks.
The State Bank, as usual, has also attempted its own forecasts for FY06. It has estimated the GDP growth rate in the range of 6.3-6.8 percent as against the target of 7.0 percent. Inflation is likely to remain close to the target of 8.0 percent set in the Annual Development Plan.
The trade deficit may widen, putting further pressure on the current account, which may rise to 3.1 percent of GDP. The overall budgetary deficit could be significantly higher due to growing needs for investment and urgent requirements of the earthquake struck regions. Due to a number of factors, FY06 will present a challenging environment for the conduct of monetary policy.
While the description of actual developments during 2004-05 and the forecasts for the current year, though quite comprehensive, could be regarded as a kind of run of the mill observations, the concerns expressed by the State Bank in certain areas of the economy are quite incisive and thought-provoking. In all, the authors of the report have listed five "niggling issues that need to be addressed expeditiously if the long-term growth trajectory is to be sustained."
First and foremost, the persistently high domestic inflation, driven by demand pressures, supply side issues and structural factors, is troubling. Second, the strong growth in both agriculture and industry is narrowly based and is a point of some unease.
Third, the fact that a sharp drop in savings parallels the rise in consumption raises a note of disquiet. Fourth, this decline in national savings is mirrored also in the reversal of the current account balance from a surplus in FY04 to a large deficit in FY05.
Fifth, a potential vulnerability lies in the country's fiscal position, which will be sorely tested in the aftermath of the recent earthquake. All these weaknesses need to be treated as challenges by the policy makers. According to the report, "the economy is now delicately poised - on the one hand, the continuation of fiscal discipline, prudent monetary policy and focussing attention on bettering infrastructure and social sector indicators clearly indicate the possibility that the economy can maintain its long-term growth trajectory.
On the other hand, if the weaknesses in key indicators such as the lack of buoyancy in taxes, growth in current expenditures and external sector imbalances are not addressed, the economy could begin to suffer deviations from the growth path so diligently restored in the last four years."
The State Bank, in our view, deserves commendation for the hard work in ensuring that its annual report is utterly objective and highly useful for the policy makers. Unlike other official documents, it has refrained from unnecessary aggrandisement and show of optimism.
For instance, while the economic managers of the government do not tire of boasting about high growth rates and their sustainability, the report points out, without mincing any words, that such a growth trajectory is only possible if certain tough conditions are met.
Another quality of the report is the discussion of various policy alternatives at a number of places and the reasons recorded for preferring one option to the other. Such an analysis is bound to enhance the quality of the report.
For instance, outsiders can now easily see why the State Bank took so long in tightening the monetary policy. One could differ with the State Bank's views but at least the other side of the story is not a secret anymore.
A highly valuable contribution of the report is the flagging of niggling issues and the outlining of necessary pre-requisites for sustained development. This, we feel, was necessary in view of the creeping complacency and the belief in the government circles that the economy is now strong and resilient enough to withstand pressures and grow automatically.
The State Bank has clearly pointed out that inflation is a concern, growth is narrow based, savings are declining rapidly, current account deficit is widening and weakening fiscal deficit raises the specter of a frittering away of the hard won fiscal space achieved in recent years.
The State Bank's report is perhaps the first official document admitting clearly that additional resources would be required to meet the challenge of building new towns over the ruins etc in the quake affected areas and this is not an easy task.
The State Bank has also told the government policy makers in very clear terms that economic revival will be at stake if the emerging imbalances in the economy are not addressed.
In our view, the State Bank has done its duty in highlighting the issues and it is now upto the government to devise appropriate responses failing which the economy could again begin to move in the reverse gear in the not too distant future.
Although State Bank has given reasons for the conduct of monetary policy, yet we feel that the policy actions falling within its own domain also need to be reviewed. The State Bank continues to give high priority to the growth of the economy at the cost of inflation control which is the foremost duty of the central banks all over the world.
In order to probably justify its position, the State Bank has quoted a study indicating that inflation in excess of 8-12 percent hurts growth in the long-run. We would like to advise the State Bank that such studies are based on certain assumptions and are not definitive.
Instead of being content with the above range, the State Bank needs to take appropriate measures to reduce the inflation rate to a tolerable level of about 6 percent or so. Inflation always favours the rich, punishes the poor and is highly regressive.
The deterioration in the saving rate which could be highly damaging for the growth prospects of the economy is also partly the result of the policies of the State Bank to keep the interest rate structure depressed. Low interest rate environment also encourages the hoarding of commodities which puts further pressure on prices.
After heavy doses of injection of liquidity in the economy during the last few years, money supply and credit off-take by the private sector has declined in the last three months.
If inflation still continues to be at a high level, the State Bank should tighten the monetary policy further to get the desired results. It needs to be realised that rising inflation is the worst enemy of the poor and common man who do not care about the growth rates and the level of foreign exchange reserves etc.
SBP has been claiming the rise in import bill, besides oil, is largely due to higher machinery imports. That would enhance the productive capacity in the country and boost exports. Import of CKD vehicles and cellular phones are placed under the machinery category. How they will add to productive capacity is indeed questionable.
The State Bank should also not stake its reputation on defending the rupee irrespective of the developments in the external sector. The trade deficit of the country has widened by 188 percent during the first quarter of FY06. The position of current account also seems to be deteriorating.
Foreign exchange reserves would have dwindled by a much greater margin if one-off inflows were not made available to the country in FY05. All these factors suggest that State Bank should refrain from frequent intervention and allow the rupee to find its own value in the foreign exchange market.
This could effectively mean some depreciation of the rupee but would solve most of the external sector problems.