Since the risk to inflation outweighs the risks to growth in the near future, the State Bank of Pakistan has decided to tighten its monetary policy by raising its policy rate by 50 basis points to 10.5 percent. And, this move has further drained off over Rs 12 billion from the banking system by enhancing the Cash Reserve Ratio by 100 basis points to 8 percent on deposits of less than one year maturity effective February 1st 2008.
According to SBP's monetary statement, issued on Thursday, widening fiscal and external account imbalances beyond targeted levels reflect high demand pressures in the economy, and are aggravating pressure on already high inflation (8.7 percent in December 2007 ie 2.3 percentage points higher than in December 2006).
In the backdrop of domestic political noise and global developments, says the SBP, it is highly unlikely that these deficits and their financing requirements come close to the targets set at the beginning of the current fiscal year.
The SBP felt that its present monetary stance was losing its impact due to excessive budgetary borrowing from SBP - 60 percent of the fiscal deficit financed by the Central bank in first half of FY08. This has resulted in broad money growth (M2) of 19.2 percent on annualised basis.
It is of vital importance that fiscal slippages be reined in during the second half of FY08. The government must mutually agree with SBP to reduce a portion of its stock of paper (MRTBs) - now at Rs 624.6 billion relative to the average annual Rs 305 billion for the last five fiscal years. The SBP advice for this reduction is to hold bulky/Jumbo auctions of PIB's, higher issuance of sovereign Sharia compliant instruments and an endeavour to generate more net inflows in National Saving Schemes.
According to analysts, the SBP could have chosen the easy path and instead raised the Statutory Liquidity Ratio (SLR) for quick off-loading of MRTB's onto the banks - but stock of MRTB's is now so large that it would have definitely crowded out private sector borrowing from the banking system. Private sector borrowing is 10.4 percent in July-December 2008 which is 0.2 percent higher compared to 10.2 percent in the corresponding period. But it is expected to be Rs 375 to 400 billion for the whole year.
The SBP said it is too early to infer the full FY08 growth prospect but according to four months of available data - Large Scale Manufacturing (LSM) growth has decelerated to 7.6 from 8.4 percent in comparable periods. Recent events coupled with power shortages are further likely to adversely affect manufacturing activities.
Except for sugarcane and maize, output of other major crops, says SBP, witnessed either a decline in production (cotton) or deceleration in output growth (rice). Due to delayed start of sugarcane crushing and water shortages at the time of sowing, area under cultivation of wheat shows a three percent decline.
Higher domestic sale of cement, credit for housing finance, foreign investment in construction, cement and metal, import of steel and iron and construction machinery, indicate strong construction activities in the economy, says SBP. Smooth political transition, establishment of law and order, effective enforcement of property rights and legal business contracts, and commitment in addressing energy shortages can really go a long way in creating an environment that is conducive to long term growth prospects of the economy, concludes the SBP report. Rs 12 billion drained off with 100 bps hike in CRR