The monetary policy committee although has maintained its stance since May 16; but the votes for status quo or to cut keep on swinging in the past few reviews. In July and Sep, eight out of ten members of Monetary Policy Committee were for no change as inflation was expected to surge and vibes were to remain cautious. In Nov, after seeing depressed food prices, doves started to dominate - 4 members were for 25 bps cut, and in Jan, 3 votes were for cut.
What is the vote count in March? This will be revealed once the minutes are out in a month or so; but by mere simply looking at expanding CAD, the hawks should have opened up wings. The State Bank has two options to deal burgeoning current account deficit - either to have a tight monetary policy or to let the currency to depreciate. A combination of both is an appropriate strategy.
Knowing that PMLN is gaining political mileage by sticky currency; letting the rupee to depreciate is not on the cards before the elections. Hence, there was no rational of any rate cut on Saturday. But, is not easing monetary policy enough to keep the reserves growth intact?
Theoretically, capital flows out when interest rates are low, adjusted to inflation and risk, to outside world. With real effective exchange rate appreciation of 25 percent, capital should have flown out of the country already. That is not happening because there is not much foreign capital here. If there is any, it's invested in the long term projects. While despite the fact PSX was the global star performer in 2016, foreign portfolio investment fell consistently.
The opportunity cost of keeping artificially pegged currency is probably in the form of FDI not coming into the country. The experience of foreign investor, especially in telecom and financial sector was not very rewarding in dollar terms during early 2000s. When they invested, the rupee dollar parity was fixed and it was at a time when their bottom lines were becoming green that currency was depreciated by a quarter. All the returns were eaten by sudden depreciation of currency in 2008 and it kept on falling till 2014 when Dar intervened to lock it.
One of the reasons inflation has kept low is because of sticky currency. And any depreciation in currency would inflate prices. But imports tend to increase when the prices are low.
Pakistan is a consumption based economy; at 89 percent of GDP last year. This partially explains why trade deficit is getting too high in the country. SBP is confident that CAD may be lowered in remaining four months of the fiscal year relative to last few months. It's expecting $450 million of CSF and some rise in exports due to cash incentives and some curb in non-essential imports due to 100% cash margins on an array of products including passenger cars.
But that all is not enough as machinery imports and petroleum group which constitute a two-fifth of total imports are ought to increase. Remittances may increase a bit due to high season coming up; but the trend is declining. No big chunk FDI, apart from Engro Foods deal.
The reserves can only maintain at the cost of external borrowing. But for how long? The domestic industrial activates ought to pick to generate exportable surplus. The LSM grew by 3.5 percent in Jul-Jan 17 versus 4.5 percent same period last year. However, this year growth is broad based - driven by consumer and construction demand. Last year it was government support that drove automobiles and regular gas supplies boosted fertilisers production.
The credit side is showing that economic activities are picking up. Private credit is growing and within it fixed investment is rising, and there is sudden surge in consumer finance. The bank deposits are finally growing with currency in circulation's steep upward curve is straightening a bit; yet the currency to deposit ratio is increasing.
That has to be addressed; keeping low interest rates making savings dearer in already a consumption based economy. Savings generate investments, and the country's investment to GDP is too low for keeping a targeted growth momentum of 5 percent in the medium to long run.
The bottom line is for sustainable economic growth amidst fears of twin deficit warrants a tight monetary stance.