NationalVolume 14 Issue # 13

State Bank tightens monetary policy

The State Bank has decided to raise the policy rate by 25 basis points to 10.25%, effective from February 1, 2019, for the next two months. The 10.25% rate is the highest in the past seven years. The tightening of monetary policy is contrary to the desire of the federal government which sought to keep the policy unchanged due to adverse implications of monetary tightening for the economic growth. The Monetary Policy Committee (MPC) took the decision of hiking the discount rate with a majority. Some members of the MPC were in favour of keeping the discount rate unchanged at 10 percent but the majority’s view prevailed. The SBP had hiked the discount rate by 450 basis points in the last 12 months starting from 5.75 percent to now 10.25 percent.

Highlighting four major challenges being faced by the country’s economy including a persistent surge in twin deficits, the State Bank of Pakistan announced a new policy rate in a bid to further support the move for stabilising the economy. The reasons cited by the SBP indicate that exchange rate depreciation and monetary tightening had failed to contain the current account deficit: “Challenges to Pakistan’s economy persist and despite narrowing, the current account deficit remains high and fiscal deficit is elevated; core inflation is persistently high and this situation calls for continued consolidation efforts.” The current account deficit narrowed only 4.4% in first half of the current fiscal year to $8 billion. The SBP has also lowered the economic growth projection for the current fiscal year to around 4% from its two-month-old estimate of over 4%, in the last fiscal year.

Explaining the rate hike, the SBP governor said that the MPC noted that the impact of stabilisation measures implemented so far was gradually unfolding and confidence was improving amidst reduced economic uncertainty, but (i) the fiscal deficit is yet to show signs of consolidation despite a reduction in PSDP spending; (ii) although a gradual improvement in the current account deficit is visible, it remains high; (iii) a marked shift in the pattern of government borrowing from scheduled banks to SBP entails inflationary concerns; and (iv) even as stabilisation measures gradually work through the economy, underlying inflationary pressures persist. Based on the above, and after detailed deliberations, the MPC decided to raise the policy rate by 25 bps to 10.25 percent.

Economic data confirm that the stabilisation measures implemented over the last one year were taking hold and key monthly indicators were showing visible signs of deceleration in domestic demand. But the average headline Consumer Price Index (CPI) inflation stood at 6% in the first half of FY19, which was considerably higher than 3.8% in the same period of last year. Core inflation, measured by non-food and non-energy components of the CPI basket, reached 8.4% in December 2018. Going forward, the second-round impact of exchange rate movements, upward adjustment in gas and electricity tariffs, and higher government borrowing from the SBP are likely to be offset by the lagged impact of the increase in policy rate and fall in international oil prices on inflation.

Experts hope that the current account deficit would remain around $13-14 billion. However, the first six-month trend shows that the deficit could still go beyond the desired level. Pakistan’s gross foreign currency reserves stood at $8.2 billion. The reserves decreased due to market interventions, defence-related payments and external debt servicing. In absolute terms, net budgetary financing from the SBP reached Rs3.77 trillion from July 1 to January 18, which was 4.3 times the amount borrowed during the same period of last year. This financing will potentially have inflationary consequences in the future.  Even as stabilisation measures gradually work through the economy, underlying inflationary pressures persist.

In this context, it is important to note that the increase in the discount rate will add about Rs25 billion to the debt servicing cost, which is expected to hit Rs2 trillion – the highest ever. However, the permanent solution to external sector problems lies in the adjustment in the rupee’s value. The overvalued rupee was subsidising imports and putting an additional burden on exports.What is needed is to find a true equilibrium and that equilibrium is what the market determines. The overvalued rupee had negative implications for Pakistan’s economy. It seems that the central bank may face difficulties in convincing the International Monetary Fund that does not endorse a nominal increase like that of 25 basis points as an effective tool. The budget deficit continues to be high and it is imperative to bring down the fiscal deficit and current account deficit for economic stability. The fiscal deficit for first half of the current fiscal year is likely to be higher than the same period of last year. The SBP has reiterated its earlier view that the fiscal policy would have to be proactive and play a supportive role in generating conditions for stability and sustainable growth.