"To mitigate the implications of these risks it is important to continue with the current monetary policy stance and keep the policy discount rate unchanged at 15 percent", said SBP Governor Salim Raza. Issuing monetary policy statement here after a meeting of SBP Central Board of Directors on Saturday, he said that demand pressures in the economy had not completely dissipated despite a slowdown in economic activity.
-- SBP to support trade and industry by supporting banks,
-- Fiscal, CA deficits magnitude, slippages risks remain high,
-- SBP Central Board of Directors has decided that monetary,
-- policy statement will be issued on quarterly basis, and the next policy statement will be issued by the end of April 2009,
-- Demand pressures have not completely dissipated despite a slowdown in economic activity,
With no change in policy rate, he also announced to issue monetary policy statement on quarterly basis due to the rapid development in the economic indicators. "SBP Central Board of Directors has decided that monetary policy statement will be issued on quarterly basis, and the next policy statement will be issued by the end April 2009", he said.
He said that the extent of risks and vulnerabilities, which the economy had faced during 2008, had reduced, "but we would need to remain watchful of the emerging risks and challenges". He said: "In common with much of the world, we are passing through a difficult year, with challenges for economic management, hardship for the common man and tough conditions for businesses. In our case, the accumulation of excess demand over the past several years spilled into twin deficits and strong inflation that slowed capacity for growth.
"Increasingly, firm and co-ordinated fiscal and monetary action has set in train positive processes for the macro-economic stabilisation that is necessary to restore growth. But we face a period of continued discipline to consolidate the directional improvements that are beginning to be made."
He pointed out that factors such as vulnerability of the external sector due to high oil and other commodity prices and persistence of high imports and weak prospects of foreign investment had all moderated considerably owing to improvements related to each area. He said that inflation, which started rising sharply in early 2008, started decelerating in September 2008 and the deceleration in CPI inflation was moderate relative to SPI and WPI inflation (see chart).
He said that progress had been made with inflation over the last four months, "but it is very stubborn" in the core inflation (ie non-food and non-energy). He said: "The slow improvement in core inflation, while it has a structural element, is primarily owing to the fact that non-fuel and non- food items, such as wages and rents and fares, etc, continue rising after the supply side shocks recede.
"This more entrenched trend is because inflationary expectations remain; for the good reason that we have had 12 months of high inflation and several preceding years during which the potential for inflation breaking out in a substantial way was being developed."
He said that by the end of fiscal year 2009 there would be some reduction in both fiscal and external current account deficits relative to fiscal year 2008. "However, not only is the expected magnitude of these deficits high but also there are risks of slippages. This signifies that the demand pressures have not completely dissipated despite a slowdown in economic activity," he said, and added that the high expected average CPI inflation of 20 percent for FY09 (significantly higher than the FY09 target of 11 percent) and its persistence, reflected by core inflation measures, clearly reflected the risk on this front.
"To mitigate the implications of these risks it is important to continue with the current monetary policy stance," he said, and added that the SBP "has decided to keep the policy discount rate unchanged at 15 percent".
Elaborating on the more recent liquidity issues, he said that the present pressure on interest rates would have come down irrespective of the discount rate, "as we have seen an unprecedented fall in banking liquidity post-June, between July 1 and January 10, deposits have shrunk by 3.4 percent, or Rs 128 billion, while total credit has grown by 11 percent or Rs 500 billion, putting a strain of Rs 628 billion on the system, or shrinking available liquidity by about 14 percent".
He said that this was the simple counterpart of the CA deficit, and this level of contraction of liquidity would have raised interest rates in and of itself, regardless of where the discount rate was. Raza said the State Bank has taken several measures to further strengthen and segregate the responsibilities of debt and monetary management including (i)- prior announcement of the auction calendar for Treasury Bills (T-bills) and Pakistan Investment Bonds (PIBs) and a volume based approach to determine the auction result.
These are positive steps in the development of a liquid government debt market; (ii)- Ministry of Finance will henceforth be responsible for deciding the cut-off yields of the primary auctions of T-bills and PIBs on the above premise.
He said the State Bank would continue to manage the operational aspect of the auctions and there would be no change in the process as far as the market was concerned, and added that the next step in the segregation of debt and monetary management would be to work towards introducing limits on direct government borrowings from the SBP and along with a plan to eliminate the same in a phased manner over the next several years.
The SBP Governor said that some of the important policy measures and adjustments, which are a part of the macroeconomic stabilisation package, have already been working their way through the economy and are likely to contribute towards achieving stability by the end of FY09.
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Inflation starts decelerating in FY09
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Over corresponding month of last year
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CPI WPI SPI Core
Inflation*
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Jul-08 24.3 34.0 33.0 14.7
Aug-08 25.3 35.7 33.9 16.4
Sep-08 23.9 33.2 31.1 17.3
O ct-08 25.0 28.4 32.7 18.3
Nov-08 24.7 19.9 29.8 18.9
Dec-08 23.3 17.6 25.8 18.8
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NOTE: NON-FOOD NON-ENERGY:
THESE INCLUDE (i)- frequent and timely adjustments in the policy interest rate that resulted in a cumulative increase of 500 bps during 2008 kept the aggregate demand and inflation expectations from spiralling out of control; (ii)- rationalisation/elimination of subsidies, especially on petroleum products, that created problems for the government's budget of FY08; and (iii)- an inevitable yet needed and market-driven adjustment in the exchange rate helped in putting a dent in an otherwise unsustainable growth rate of imports.
He said that eventually, shocks to foreign resources in 2008 such as the global financial turmoil and domestic turbulence exposed the domestic vulnerabilities and resulted in a fall in reserves, considerable depreciation of rupee, and a persistent rise in inflation (see chart).
He said that up till FY07, rise in the current account deficit due to these increasing imports were met with the financial inflows. In FY08, however, the size of the current account deficit rose very sharply and despite the reasonable financial inflows the foreign exchange reserves depleted.
As a result, the pressure on exchange rate built up, and the rupee depreciated sharply. "Ideally, had the exchange rate been driven by the inflation differential and demand supply conditions, imports might not have risen as sharply and the abrupt widening of the current account deficit might have been avoided," he added.
The SBP Governor said that the dismal performance of large scale manufacturing (LSM) during the first five months of current fiscal year by 5.6 percent and falling private sector credit were an indication of weakening real economic activity.
Adding the fall of over five percent, with the sharpest fall in auto, electronics and metal industry and variety of reasons for this, some to do with falling demand as disposable income contracted, some with conditions in export markets, some with cost and availability of credit, power cuts and long interruptions were significant contributors.
However, this was the first time that LSM presented a negative growth during last six years (since FY04), he said. He noted that two phenomena that had hitherto diluted the effects of the tight monetary policy have changed their direction that bodes well for macroeconomic stability. He explained that there has been a noticeable decline in the volume of government borrowings from the SBP for budgetary support.
"This has been made possible because preference for subsidy took a back seat, especially after the confidence-invoking and discipline-inducing home grown stabilisation package that also paved the way for successful conclusion of Stand-by Arrangement (SBA) with the IMF. Secondly, after touching a record high of $147.3/bbl on 11th July 2008, oil prices slumped to around $40/bbl as on 27th January 2009; a fall beyond national and international expectations and projections.
"This drastic fall in international prices will provide a much-needed respite for the trade account and coupled with tight monetary policy and prudent exchange rate management will strengthen the balance of payment position. CPI inflation is also likely to benefit from this development," he asserted.
He said that despite some preliminary positive indications, it would be imprudent to lower the guard at this stage. He said that the macroeconomic indicators that have recovered and the ones likely to post improvement in the next six months justify guarded optimism on close inspection.
He said that gradual build-up of excess demand started from 2004 due to high availability of private sector credit, fuelled by low interest rates. Credit to government jumped in the later years owing to delayed passthrough in fuel subsidies of Rs 777 billion deficit, out of which almost Rs 400 billion was in subsidies.
He projected that by the end of FY09 private sector credit would reach peak level of Rs 3258 billion with 22.7 percent growth, while credit to government with a growth of 24 percent to touch Rs 1563 billion.
However, he said that going forward, as the government 's credit requirements stabilise, and the confidence in the system builds up due to the implementation of a comprehensive stabilisation program, both credit demand and supply conditions were likely to improve for the private sector.
He said that at present increased participation of banks in MTBs auctions indicated their reluctance to extend credit to the private sector and was an indication of growing risk aversion amid a slowdown in economic activity.
Furthermore, the full impact of demand and liquidity management measures taken by the SBP during 2008 have yet to materialise. The SBP Governor said that there were indications of improvement in the current account balance due to falling international commodity prices and strong remittances.
"However, the balance of payments position is still exposed to several risks. First, the decline in trade deficit, which is anticipated on account of a fall in imports, may prove to be less than expectations for two reasons: (i) there may be deceleration in growth of exports due to global recession and the domestic structural bottlenecks featuring intermittent power and gas supplies; (ii) the anticipated decline in oil import bill may turn out to be less than the current projections," he said.
He said that liquidity position of the banking system is at a comfortable level, which can be gauged from the significant increase in the bank holdings of surplus government securities over and above the SLR requirement.
This surplus liquidity has increased from a low of Rs 79 billion (2.1 percent of DTL) in end-September 2008 to the current level of Rs 325 billion (8.6 percent of DTL). This comfortable level of liquidity has not only pulled down the Kibor rates but has also reduced the interbank spreads between the repo and the call rates.
SBP through OMOs has consciously kept the short-term interest rates relatively low to ensure market normalises after a liquidity stress period and to smoothen the flow of funds to the private sector and the Government of Pakistan, he added. He said that 6-month Kisor has eased off by 55 bps to the current level of 15.21 percent from 15.76 percent in November 2008. Downward movement in 3-month Kibor has been much sharper, which has come down by 98 bps during the same period.
Although the above increase in surplus liquidity indicates an improvement in the capacity of banks to lend to the private sector; the recent increased participation of banks in Treasury Bills auctions may also indicate their reluctance to extend credit to the private sector, he added.