As anticipated by this newspaper, the Monetary Policy Committee (MPC) of the State Bank has decided to keep the policy rate unchanged at 13.25 percent per annum for the next two months. In reaching this decision, the MPC has taken into account the latest key economic developments in the real, external and fiscal sectors and "the resulting outlook for monetary conditions and inflation". In the real sector, the average growth in FY20 was expected to be around 3.5 percent due mainly to the stagnation in LSM sector. However, SBP-IBA Consumer and Business Confidence Surveys show a modest improvement in the outlook for the economy. The external sector witnessed a sizeable reduction of around 32 percent (or 1.5 percent of GDP) in the C/A deficit during FY19 and this trend continued in the first month of FY20 (July, 2019) as well when this deficit contracted to only dollar 579 million compared to dollar 2.13 billion in the same month last year. This together with disbursement of first instalment of EFF programme with the Fund and the activation of the Saudi oil facility helped to raise the SBP's foreign exchange reserves to dollar 8.46 billion by 6th September, 2019, indicating an increase of dollar 1.18 billion over the end-June, 2019 level.
The developments on the fiscal front have been mixed. Revised data for FY19 showed that fiscal outcome during the year was much worse than earlier expected, with the primary deficit reaching 3.5 percent of GDP and overall fiscal deficit touching 8.9 percent of GDP. However, tax revenues (net of refunds) have grown considerably in July and August, 2019, suggesting that "the economic slowdown may not be as pronounced as may have been feared". Both CPI and core inflation have risen during the recent months. "These developments were in line with SBP's earlier projections and reflected the pass-through of earlier exchange rate depreciation, adjustment in utility prices and an increase in food prices". The MPC expected the inflation rate to range between 11-12 percent in FY20 and also considered risks to this inflation outlook. Its view was that inflation could rise above the baseline projections in case of fiscal slippage or other adverse developments and could fall earlier than expected if oil prices decline, aggregate demand slows faster than expected or the exchange rate appreciates.
A careful reading of the Monetary Policy Statement (MPS) released by the State Bank suggests that the case to keep the policy rate unchanged is based mainly on grounds emanating from evolving situation in the key variables impacting monetary policy formulation. The MPC had been steadily increasing the policy rate in the recent past, jacking it up by 725 bps since January, 2018 to 13.25 percent in the last MPC meeting held on 16th July, 2019, due to the deteriorating inflation outlook, unsustainable external sector deficit, falling Forex reserves, dwindling GDP growth rate and worsening fiscal developments. While the tightening of monetary stance was almost inevitable in such a situation, a slightly loosening of the tight policy stance could be justified when the relevant variables have either improved somewhat or seem to have stabilised to give a breathing space to the monetary authority of the country. The most glaring improvement has been witnessed in the external sector. There was a substantial reduction of 32 percent in C/A deficit during FY19 from the peak level of about dollar 20 billion during FY18 and this positive trend seems to have continued during the first month of FY20 when the C/A deficit was reduced further to dollar 579 million as against over dollar 2.0 billion in the same month a year earlier. Foreign exchange reserves held with the SBP have also risen recently and exchange rate of the rupee has improved slightly against the US dollar. It is almost clear by now that the policy of downward adjustment in the rupee rate and containment of imports has started bearing fruit and Pakistan which was almost on the verge of bankruptcy not long ago has been successful to avoid the worst scenario. The policy to engage the IMF, though somewhat belated, has also played its part to tide over the situation successfully.
The apprehensions about high inflation also seem to have subsided. There are indications that the inflation rate could be slightly above 10 percent during FY20 but would tend to decline thereafter or even before the close of FY20. It could even fall to a tolerable level of 5-7 percent in the next two years. However, such a scenario is contingent, among other things, on sound fiscal management and the behaviour of oil prices in the international market in the coming months. Contrary to earlier expectations, real sector of the economy is also expected to show a modest growth of 3.5 percent. A modest growth rate, particularly the expected improvement in the agricultural sector, would also help contain the inflationary pressures in the economy.
Although the MPC has termed the recent developments in the fiscal sector as mixed, we feel that the fiscal situation is not that optimistic. As observed in the MPS, it is true that tax revenues have grown considerably during July and August, FY20 over the same period last year but these are well short of the target by nearly Rs 64 billion which is not a small amount. Debt servicing cost is likely to grow considerably due to higher stock of outstanding debt and a sharp increase in interest rates while deficit expenditures, which were frozen at the previous years' level in the budget for FY20, are also likely to go up considerably due to increasing tensions at the eastern border of the country. The MPS itself has noted that "fiscal prudence and meeting the programme targets is essential to sustaining the improvement in macroeconomic stability", indicating clearly to the government that fiscal slippage this year is not an option and may derail the reform process. It means that the current efforts of the government to contain the budget deficit, though commendable, are not sufficient to meet the targets agreed with the Fund and may undermine the stabilisation process. The present monetary policy may have to be revised in case the government does not meet its fiscal policy commitments and violates budget projections. Overall, however, we feel that the MPC has backed itself by keeping the policy rate unchanged for the time being. This was of course not easy due to the mounting pressure of the business community to reduce the policy rate and the falling discount rates in most of the other countries.