SBP monetary policy statement: risks and challenges: outlook for second-half-fiscal year 2009

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Recent Economic Environment and Emerging Challenges: Th e impact of global financial crisis varies across countries.

1. Global financial crisis that has been brewing for over 18 months has deepened. From being a small sector problem, the crisis has widened with US and Europe ‘s financial sectors experiencing acute liquidity crunch and falling stock prices. In the last two months, the financial crisis magnified and surfaced as an insolvency crisis as evident from the collapse of large global finance houses, which had to be restructured. Given the size and dimension of the problem, the advanced countries have provided a fiscal and monetary stimulus to rescue the financial system. Central banks of major economies including the US Federal Reserve, Bank of England, and the European Central Bank stepped up their interventions infusing liquidity in the system, structuring bailout package for financial institutions with provisions for capital injections, interest rate cuts, lending and deposit guarantees, etc.

2. Latest forecast suggest that the financial crisis has now impacted the

prospects of global economic growth and it will take some time for financial markets to fully stabilise. As the financial crisis unfolded, it has caused enormous stress, uncertainty, and the fear of contagion. It initially impacted the equity and money markets and is now likely to dampen the growth prospects of Asian economies. With the US and the Europe as their key markets, this is particularly true for the export oriented Asian economies; the concept of decoupling has turned out to be quite illusive.

3. However, the magnitude, depth, and impact of the financial crisis vary in accordance with the domestic macroeconomic situation in individual countries across regions. While macroeconomic fundamentals are broadly adequate in advanced economies, the liquidity crisis brought the financial system to a halt and turned into a solvency crisis. For example, in the US, macroeconomic indicators such as the external current account and fiscal deficits as percentage of GDP and inflation are at comfortable levels but the financial sector stress is affecting the growth prospects.

Same is the case in other major economies like the UK and the euro zone. Asian economies that had adopted sound macroeconomic policies and built foreign exchange reserves aggressively over the years were also able to mitigate the consequences of spill over of the global financial crises by launching monetary and fiscal stimulus. The macroeconomic situation and the policy response in Pakistan remain different …

4. While there has been a debate that Pakistan should emulate other economies and ease fiscal and monetary policies, this is not an option. The economic situation and dynamics of the problem in Pakistan is completely different from what has transpired in other economies. Origins of Pakis tan ‘s economic stress lies in the country ‘s growing weaknesses in macroeconomic fundamentals rather than the financial sector.

Nevertheless, the timing of these global developments could not have been worse for Pakistan as the domestic macroeconomic stability is already under a lot of stress. The result has been deterioration in a number of variables such as depletion of foreign exchange reserves, weakening of rupee, rising inflation, slowdown in economic activity, and increased uncertainty. 5. In view of this, not only does Pakistan have to craft its economic policies in line with proper diagnostics, there is also a need to develop responses which do not hurt financial markets.

It has to be further recognised that the nature and extent of the liquidity constraint is quite different and remains relatively milder than in the advanced countries. Finding an optimal solution to complex and multiple issues is challenging for Pakistan given the scale of the problems and the need to tackle the intricate policy trade-offs. Therefore, while the advanced economies have an urgent need to address the financial market turmoil to secure growth prospects, the priorities for Pakistan are to achieve macroeconomic stabilisation through hard core short term supply and demand measures, which would help alleviate inflationary pressures over time.

6. To restore macroeconomic stability and shore up the dwindling confidence in the economy, SBP has been vigilant and continuously been taking a number of corrective measures. These measures, taken during the course of 2008, were meant to rein-in emerging aggregate demand pressures and fight inflationary trends: ??Two rounds of increases in SBP ‘s policy rate,

— in the cash reserve ratio (CRR) and statutory liquidity reserve (SLR) for effective liquidity management,

— Administrative measures to address the foreign exchange market issues,

— Imposition of floor on deposit rates to improve the return on savings,

— Tightening of letter of credit (LC) margin requirements to compress import demand of non-essentials.

In addition, the government took the following steps:

— Rise in the domestic prices of POL products to reduce the subsidy burden, rationalisation of electricity tariffs, and commitment to address the circular debt issue; and

— In the budget for FY09 Government committed to net zero borrowings during FY09, though SBP, for some time, has been advocating the need for retirement of stock of government borrowings from the central bank.

Macroeconomic stress however deepened as newer complicat ions arose.

7. Despite all these measures the impact on aggregate demand pressures was muted and the outcome for Jul-Oct, FY09 sharply deviated from expectations. Both the balance of payments and fiscal deficit have come under renewed strain as evident from the sharp depletion of reserves and the higher than expected recourse of the government to borrowings from the central bank. These developments underscore the need for adopting coherent and substantive macroeconomic stabilisation program with co-ordinated fiscal and monetary policies to bring the economy on a stable path. Balance of payments position condition is precarious as evident from the depleting reserves and depreciating rupee …

8. Despite strong inflow of workers ‘remittances and a robust export performance (14.2 percent in Jul-Oct, FY09) the external current account deficit continues to remain on an unsustainable trajectory in FY09 after registering a deficit at 8.4 percent of GDP in FY08. This is largely due to rise in the import bill by 35.2 percent during Jul-Oct, FY09 compared to a negligible 4.4 percent growth in the corresponding period of last year.

Strong import demand in the country and the rising international commodity prices have widened the external current account deficit to $5.9 billion ($3.0 billion during the comparable period of last year). While the decline in quantum is quite visible in many of the importable commodities, its impact has been dampened due to higher prices relative to last year, as shown in Table 4. More importantly, the oil demand has not declined and the oil import bill is still a major source of growth in the overall import bill.

9. Pressures on the external current account deficit could recede with the help of appropriate demand management steps and the falling international oil prices that are hovering around $60 per barrel. However, the benefits of this decline have not yet been realised since the average POL price paid in FY09 so far is around $123 per barrel which is still well above the FY08 average level of $87.4 per barrel. Oil bill is likely to fall in the coming months as the future contracts are structured at lower prices. The withdrawal of subsidy in the form of transfer of international oil prices to domestic market is expected to dent the domestic oil consumption. These two factors could provide a much needed respite on the trade account.

However, the perceived gains might be diluted if the current strong growth in non-oil non-food (NONF) imports continues (see Figure 1). Therefore it is imperative to check this trend to bring the trade account and thus external current account deficit to a manageable level.

10. During Jul-Oct, FY09, the financial and capital account balance shows a net inflow of only $1.1 billion (compared with $3.1 billion in the corresponding period of FY08 ) as both public and private flows werelower than expectations. Consequen tly,the SBP ‘s foreign exchange reserves have depleted by $5.0 billion with a cumulative depletion of $10.7 billion up to 10th November 2008 since end October 2007 when SBP ‘s reserves were at their peak of $14.3 billion. The dollar-rupee exchange rate has depreciated by 15.3 percent since the beginning of FY09  (see Table 5 ).

11. Rupee depreciation and fast falling reserves have generated concerns regarding the viability of the balance of payments position. Thus, calming the sentiments in the foreign exchange market through correcting the external current account imbalance is of utmost importance to ensure smooth flow of foreign inflows in the country. The continued exchange rate depreciation, which is both a consequence (through falling reserves) and partially a cause of reduced net foreign inflows, would be addressed in the process.

The solution out of this vicious cycle necessitates:

— curtailing the external current account deficit in general and import growth in particular to sustainable levels, which in turn would ease the financing requirements substantially;

— curbing the unnecessary outflows from the foreign exchange market both within and outside the economy due to prevailing uncertainty;

— curtailing fiscal deficit and eliminating subsidy in imported consumption in a calibrated manner to discourage the demand for imports;

— reducing the support to the market provided on oil imports through SBP ‘s provision of foreign exchange would also be a requirement going forward.

This type of intervention, though necessary at times, is a major source of strain on the foreign exchange reserve position. It also artificially and temporarily dilutes the real adjustments in the exchange rate that are required in the face of the fast changing macroeconomic picture.

12. Ensuring unhindered and substantial inflow of external financing poses the foremost challenge for the economy. Initially, these much needed foreign inflows will have to come through official sources; the private inflows will follow later once overall stability resumes in the country. There are three issues regarding their prospects. First, the global financial markets are in the midst of a once-in-a-life-time crisis and consequently the global investors have become extremely risk-averse.

The prevailing complex law and order situation in Pakistan is not helping either. This risk aversion is evident from the sharp rise in Credit-default Swap (CDS) points on Pakistan ‘s 5 -year sovereign bond which touched 5000 bps during October 2008 (see Figure 2).1 Second, the rating agencies like Moody ‘s and S&P have recently downgraded Pakistan ‘s bond ratings further.Third,the instability in the exchange rate is keeping investors at bay.

The resulting fall in net foreign assets along with strong credit demand and seasonal facto rs caused liquidity shortages in the system.

13. These external sector developments have resulted in excessive drain of rupee liquidity from the system by Rs92.7 billion during 1st July to 1st November FY09 (see Table 6). The net foreign assets (NFA) of the banking system have contracted by Rs327.3 billion during this period. Despite pre-emption of SBP resources by the government, the strong demand for credit from both the Public Sector Enterprises (PSEs) and the private sector has further tightened the liquidity conditions. Credit requirement of PSEs has increased enormously (Rs62.8 billion during 1st July to 1st November FY09) mostly due to the issue of circular debt among the PSEs and the oil companies, while the demand for credit from the private sector has also increased sharply (Rs125.6 billion during 1st July to 1st November FY09 as opposed to an expansion of Rs60.5 billion during the corresponding period last year).

The increase in the latter is probably due to the beginning of the credit cycle and may also be a reflection of: one, companies are hoarding cash in light of the liquidity concerns; and two, the risk that this credit is being used in speculative activities.

14. The market expectations that the government is planning to pull out the public sector/government deposits from the commercial banks is causing further anxiety in the market from the liquidity perspective. Adding to the pressures of the market liquidity conditions is the conversion of deposits into cash. During 1st July to 1st November FY09, there was a sharp reduction of Rs224.7 billion in total deposits of the banking system and an increase of Rs131.1 billion in currency in circulation.

These trends in banking system liquidity partly reflect seasonality as the currency in circulation normally increases around the Eid festival putting temporary pressure on interbank liquidity. Also, liquidity constraints vary by bank; being steeper for banks with weak deposit mobilisation and relatively higher withdrawals. The liquidity pressures became visible in sharp increase in overnight call rates …

15. The liquidity constraint in the system has resulted in a rising trend in overnight call rates and reduction in excess liquidity held by banks over and above the required amount. In addition, the lack of liquid assets eligible as collateral for borrowing under Open Market Operations (OMOs)/discounting with some banks shot up the call rate to abnormally high levels.

16. Initially, the banks met liquidity requirements by reducing excess reserves maintained in the form of government securities. As a result, the excess liquid assets (mainly T-bills) with the banks declined to the lowest level of 2.2 percent of the time and demand liabilities (TDL) by 11th October 2008 (see Figure 3). These have now improved to 6.7 percent of TDL by 1st November 2008.

17. Reduction in T-bill stock (see Figure 4) has limited banks ‘ ability to access the discount window and participate in OMOs, forcing them to borrow funds from the call interbank market. Consequently, the activity in the call market increased relative to the repo market and the overnight call rates rose to as high as 45 percent during the period from 4th-11th October 2008, resulting in the widening of liquidity spread in the overnight market (see Figure 5). Similarly, KIBOR of all tenors have been rising consistently over the past three months. For example, the 6-month KIBOR has reached to 15.76 percent on 11th November 2008.

18. SBP has been closely monitoring these developments in monetary aggregates and the interbank liquidity position. Acting proactively, SBP made a net injection of Rs272 billion in the system through 35 OMOs conducted during 1st August to 11th November, FY09. In addition, banks have been allowed effective and liberal access to the discount window that resulted in availing of Rs387 billion during this period (see Table 7).

19. To ease the liquidity conditions further, SBP has taken a series of additional measures (see Annexure for details). These measures are specifically aimed at accommodating the extraordinary liquidity requirements of the banking system and not intended for any change in the monetary policy stance. Having said that, SBP stands ready to take all necessary actions to address the overall and bank specific liquidity problems in the banking system. Government borrowing from SBP continues to increase unabated causing further complications for monetary management.

20. The emerging liquidity issue has somewhat over-shadowed the issue of government borrowings from the SBP. After clocking an all-time record borrowings of Rs689 billion from the SBP in FY08, government borrowings have continued to rise unabated in FY09 also (see Figure 6). From 1st July to 8th November 2008, the government has borrowed Rs369 billion from the SBP against a quarterly retirement of Rs21 billion in FY09 as proposed in the last monetary policy statement and zero borrowing commitment of the Ministry of Finance.

The non realisation of the desired external inflows and non-bank borrowings for budgetary financing is not helping the government ‘s reliance on SBP borrowings. In the present circumstances, where NFA of the banking system are declining and there are liquidity problems in the market, this heavy borrowing from the SBP, though injecting liquidity in the system entails complications for monetary management and does not bode well for the overall macroeconomic stability on various fronts.

21. First, continued magnetisation of fiscal deficit indicates unfettered increase in the budget deficit, which is an imprudent policy stance under the present precarious situation of our economy. This expansionary fiscal stance has stoked up aggregate demand and thus inflationary pressures. It also represents rising dis-savings, which the economy can ill-afford given the burgeoning size of the fiscal deficit and its consequences on external current account deficit.

22. Second, the borrowings from the SBP lead to expansion in reserve money, which makes it difficult to meet the indicative monetary expansion target consistent with the overall macroeconomic framework. If the current trend continues, the broad money expansion target for FY09 may also be missed, as was the case in FY08, despite a contraction in the NFA. Even if the M2 expansion turns out to be close to the projected growth, it should not be construed as a positive development as it reflects weaknesses in the external and fiscal sectors. More importantly, a change in the composition of monetary aggregates causes a disproportionate increase in rupee liquidity relative to the availability of foreign exchange. This in turn puts pressure on domestic prices and erodes the external value of the currency.

23. Third, part of the adjustment in the policy rate announced since the beginning of FY08 was to accommodate government borrowing requirements from the market through the auction mechanism. However, the persistent and higher-than-projected increase in government borrowings and the inflationary expectations have resulted in a sharp increase in T-bill rates during a very short time span, which is not in line with SBP ‘s assessment of the issue at the time of the last monetary policy statement announced for the next six months. At the same time, due to tight liquidity conditions, banks have shown reluctance to participate in the auctions and are positioning to seek higher returns in line with demand for borrowings.

This has rendered the securities held by banks over and above the reserve requirements (to participate in the interbank market) to fall making it difficult for the SBP to address the liquidity shortage in the market through its collateral based OMOs and discount window.

24. Fourth, the sheer size of the MRTBs (Rs1.4 trillion), the instrument through which the government borrows from the SB P on tap,government ‘s continued recourse on central bank borrowings,the overall liquidity position,and banks ‘ behaviour in the T-bill auctions have made the overnight interest rate quite volatile. This has complicated monetary management considerably and has diluted the monetary policy transmission mechanism. Uncertainty regarding other market interest rates hampers the liquidity as well as business decision making process in the economy.

25. In light of these factors, greater fiscal adjustment is warranted in order to support the required monetary tightening. These measures include, but are not limited to, rationalising expenditures, increasing revenues, and diversifying borrowing sources. Recent adjustments in the domestic prices of POL products and electricity tariffs to reduce the subsidy burden are steps in the right direction.

Inflation expectations and falling real interest rates are disincentives to save, aggravating aggregate demand pressures.

26. It is not only the government ‘s credit requirements tha t are quite high but the private sector credit demand also remains strong. During 1st July to 1st November, FY09 the credit utilised by the private sector stood at Rs125.6 billion compared to an expansion of Rs60.5 billion in the comparable period of last year. This strong growth partly reflects the higher input prices that the businesses have to pay.

Although the nominal weighted average lending rates (marginal) have risen by 352 basis points since April 2008 due to the two rounds of monetary tightening in May and July 2008, the strong demand at the current productive capacity of the economy is fuelling inflationary pressures. A key reason for this behaviour is the prevailing negative real interest rates and expectations of continued high inflation (see Figure 7). Both these factors indicate strong incentives to borrow. Thus it is of utmost importance to stem these inflation expectations and raise the real cost of borrowings.

Controlling inflation, therefore, has become all the more important to restore ma croeconomic stability.

27. The tight monetary policy stance of the SBP is essentially aimed at managing these inflation expectations at levels that ensure price stability over the medium term. However, there are several challenges faced by the SBP in this context. First, high inflation during last year will have a strong inertial impact on inflation during FY09. For example, even if consumer prices remain constant (ie monthly inflation change is zero)at October 2008 ‘s level from November onwards,average in flation will be close to 20 percent for FY09.

28. Second, the pass-on of international oil prices to domestic consumers, adjustment in power tariffs, revisions in GST and import duties, depreciation of rupee, and expectations of higher wages due to high inflation are all likely to add to the inertial effect of last year ‘s inflation. The actual 12-month moving average CPI inflation has already reached 17.7 percent in October 2008, while YoY CPI Inflation is standing at 25 percent. This clearly indicates that average inflation for FY09 could easily exceed 20 percent (see Table 8).

29. Third, an even more disturbing aspect of these inflation dynamics is that it has become wide spread. This is evident from the large number of CPI items witnessing double digit rise in prices. Out of a total of 374 items in the CPI basket, 201 items rose by more than 10 percent in Q1-FY09 compared to only 13 items in Q4-FY08 (see Figure 8). This is being reflected in continued acceleration in core inflation measures. The Non-food Non- energy (NFNE) measure of core inflation rose to 18.3 percent in October 2008 from 13.0 percent in June 2008. Similarly, the 20-percent trim measure jumped to 21.7 percent from 17.2 percent in June 2008.

30. Fourth, empirical evidence clearly suggests that inflation of the magnitude that is currently prevailing is detrimental for growth prospects of the country. Thus, bringing inflation down over the medium-term is essential for restoring and sustaining the growth prospects. It would be prudent to consolidate growth at a relatively low level for couple of years to ease the inflationary pressures.

31. Fifth, whereas the aggregate demand pressures have not yet subsided, productive capacity as reflected by data on large-scale manufacturing is declining due to the law and order situation and structural weaknesses such as power shortages etc reflecting a widening output gap (the difference between aggregate demand and productive capacity. If the domestic demand grows at 5.0 percent (which is less than the last five year average of 6.6 percent) and the real GDP grows by 4.0 percent in FY09, the difference between domestic demand and supply is expected to widen further (see Figure 9).

Therefore, the output gap is likely to remain more or less unchanged, if not increased. As a consequence, the anticipated effect on inflation through this channel may not be realised. Thus the need to curb aggregate demand has heightened and the role of fiscal as well as monetary policy in addressing this predicament has become all the more important.

32. At the same time all necessary steps should be taken to enhance the productive capacity of the economy. One key input in this regard is the substantial increase in investments for this purpose. In the wake of dwindling availability of foreign savings, generating and channelling domestic savings – public as well as private – can play a significant role in meeting the investment requirements. Thus, curtailing this output gap would in fact help in reducing the saving investment gap in the economy, thereby reducing the reliance on external resources. To encourage savings the real returns will have to be increased significantly.

— B. Outlook for FY09

33. The importance of coping with the above mentioned challenges and mitigating the risks appear all the more important given the fact that even if the current encouraging trends in international prices and domestic demand pressures continue, the end of the year situation though shows improvement over the current and the FY08 levels, the outcome appears still away from the desirable and sustainable levels.

34. Specifically, inflation is expected to decelerate during H2-FY09 as the global commodity prices are declining and the monetary tightening measures adopted in May and July 2008 are anticipated to have a lagged impact on inflation. Thus, the YoY headline inflation is projected to come down from 25.0 percent in October 2008 to around 14 percent by June 2009, while on average basis, inflation will be closed to 21 percent for FY09; well above the 11 percent target for the year.

Although the deceleration in inflationary pressures are encouraging, the need to bring it down to single digit level remains a top priority as the level of inflation consistent with sustainable growth is estimated at 4-6 percent for the Pakistan ‘s economy.Achieving this objective in the medium-term requires aligning aggregate demand in the economy in line with the aggregate supply.

35. Imports are anticipated to slow down considerably owing to the falling international commodity prices and domestic demand moderation. Assuming the current level of international oil prices continue for the remainder of the current fiscal year and a slowdown in domestic demand is realised due to a depreciated rupee, import growth for FY09 is expected to be around 2.0 percent and may even turn negative.On the other hand,the growth slowdown/recession in Pakistan ‘s major trading partner countries, particularly US, EU, and Japan, is likely to have an adverse effect on our exports.

It is projected that exports earnings may register a growth of around 10 percent during FY09. Based on these projected imports and exports and ass uming a continuation of existing trend in workers ‘remittances,the external current account deficit is estimated to lie between 6.2 to 6.8 percent of GDP. Although this deficit is showing improvement over the last year, it is still unsustainable. Given the uncertainty regarding the foreign inflows and the need to build up the country ‘s foreign exchange reserves to end -June 2008 levels, the ‘financing gap ‘ is expected to be around $$4.5 billion.

36. Given the urgency and commitment of government to eliminate reliance on borrowing from the SBP to finance the fiscal deficit and the lower availability of external financing, the fiscal deficit will have to be cut considerably, even lower than the projected 4.7 percent of GDP target for FY09. This translates into a very well defined prioritisation of expenditures and strong revenue mobilisation efforts.

37. The impact on the monetary sector of these expected developments in the external and fiscal sector will be reflected in a monetary growth of around 12 to 13 percent. The projected improvement in the external current account deficit and the government efforts in further reducing its fiscal deficit than initially planned, will not only allow monetary growth to remain within this desirable limit, but also help in improving the composition of M2 – ie by increasing the share of Net Foreign Assets (NFA) and containing the growth in Net Domestic Assets (NDA). Moreover, the lower government financing requirement from domestic sources will allow higher credit to private sector.

38. With a slowdown in aggregate demand as expected due to declining external current account and the fiscal deficit, the overall growth in the economy is expected to trim down to 4 percent during FY09. Worsened law and order situation and structural weaknesses such as power shortages etc are mainly responsible for this slowing economic growth. An economic growth of 4 percent is consistent with the expected developments in the fiscal, external, and monetary sectors and inflation outlook.

While removing these bottlenecks is imperative in achieving sustainable economic growth, in the interim period focus of macroeconomic policies should remain on curtailing domestic demand. Though this growth is lower than the target of 5.5 percent and actual estimated growth of 5.8 percent in FY08, decision whether this growth should be maintained or even sacrificed depends on the evaluation of the trade-off between inflation and growth.

39. In conclusion, it must be remembered that tight monetary policy is only one ingredient of the macroeconomic stabilisation program. Several stabilisation and structural adjustments in the fiscal, external, and financial sector are required immediately and in the medium term to put the economy back on a stable path. The crux of this progr am revolves around building the country ‘s foreign exchange reserves supported with appropriate exchange rate policy and bringing the fiscal deficit to sustainable levels by rationalising expenditures and strengthening tax revenue generation. It is anticipated that fiscal tightening of the desired level will ensure that monetary tightening stance is not undermined.

Table 1: Global Financial Indicators

Global equity markets:

Sources: Bloomberg

1 Morgan Stanley Capital International

2 Spread between 3-month US T-bill and 3-month $ denominated LIBOR; usually around 0.5% 3 losses from write downs: subprime NPLs, margin call defaults, revaluations, leveraged loan commitments

Table 2: Economic 2008 )

Source: Bloomberg, WEO-October 08 & Central Bank Websites

1.% of GDP; 2 September 2008; 3 Q3-2008; 4 October-08; 5 2007; 6 FY08.

Table 3: Balance of Payment Statistics (in billion US $)

Source: SBP

Table 4: Major Imports with

Decrease/Increase in Quantum million US $:

Source: Federal Bureau of Statistics

Table 5: Trends in Exchange Rate

— Weighted average mid rates

Table 6: Monetary Aggregates (Flows)

billion rupees:

— Includes credit for commodity operations, net budgetary support and net effect of Zakat fund etc.

Source: SBP

Table 7: Activity in Interbank Market:

— 10th November 2008

Table 8: Inflation Indicators:



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