There are a couple of developments that must have made the decision easier for the central bank. Firstly, inflation has come down to 10.5 percent in September (Average inflation for 1QFY11 is 11.5 percent). Then government borrowing from SBP was down by Rs104 billion in the first quarter, giving a much-needed respite to the note printing presses. This also allowed private sector credit to tick up despite persistent energy challenges and the towering fiscal deficit.
In all probability, inflation for the full year will remain below the targeted 12 percent. So SBP has kept the real interest rates marginally positive, even after 150 bps reduction. At the same time, central banks in advanced economies appear to be consistently betting on negative real interest rates despite rising inflation.
The writing is on the wall. The central bank and government are all set to spur economic growth by facilitating private credit at a time when inflation is taming. Lately, MoF has dealt with the commercial banks to transform the advances of inter-agency energy circular debt and to settle the unpaid claims on account of its commodity operations, by issuing government securities of about Rs400 billion.
These resources that have remained clogged in the banking system can now be channelled towards productive activities, asserted the MPS. SBP is betting on the assumption that credible efforts to curtail the emergence of incremental debt in energy sector will be taken by the government. These would in turn, reduce the inflationary pressure; plugging the gap of aggregate demand and aggregate supply by increasing supply. This is a bold assumption considering the policy inaction on part of the present government.
Still, the market had anticipated a rate cut of at least 100 bps, as the 6-month T-bill rates and 10-year PIB rates in secondary market decreased by 114 and 136 bps points, respectively between August 1 and October 7, 2011.
SBP is hopeful that the rate cut will have a favourable impact on the demand for credit by private sector over and above their working capital needs, despite the fact that private credit has declined by Rs84 billion in July-August period (July-August FY11 decline:Rs46 bn). Optimism, it seems, is all over the place.
The other good omen is the shift in the demand for T-bills from 3-month paper to 12-month papers - in 1QFY12 the amount offered by banks in primary auctions for the longer-term paper has increased to 63 percent from 25 percent in the previous quarter. This will not only reduce roll-over risk of short term debt, but also indicates that inflation expectations are trailing down.
Nonetheless, the elephant in the room is the fiscal deficit and private sector demand and thus investment in the economy mandates fiscal reforms, especially in the wake of declining external budgetary support. It is imperative to increase the tax to GDP ratio, emphasised the SBP.
However, without much effort in this regard, the government is increasingly relying on the banking system. The government raised Rs851 billion (as against a target of Rs750 bn) in 1QFY12 and has set a second quarter target of Rs1025 billion, including an additional requirement of Rs63 billion.
Now it will be interesting to see what the rate cut can do to address the strained liquidity in the private sector which has been brought on by the burgeoning borrowing of the government. Although the current account has displayed reliance on the back of growing remittances and an improved trade balance; there has been a decrease of $1.1 billion in foreign reserves during 1QFY12. The local currency has also been volatile; having shed 1.7 percent against the green back in the first quarter of the current fiscal.
So even though the well fed stock brokers would have undoubtedly spent this past weekend feasting on sweets and the suited, booted bankers would have toasted to the MPS; the central bank itself has a lot of pondering ahead of it.