The State Bank of Pakistan (SBP) has taken various measures to manage inflation and interest rate. In September 2013, SBP linked minimum rate of return on average balances held in saving deposits with the floor of the interest rate corridor, which means return on saving deposits cannot be more than 50 bps lower than the floor of the interest rate corridor, which is currently at 7.5 percent. This measure is part of a long initiative to generate deposits and push banks to share returns with the deposits. In an ideal environment, banks would not give any interest on deposits since it is a cost to the bank. Growth in deposits is necessary to meet the credit requirements of the economy. The increases in policy rate in September and November 2013 have helped the fiscal authority in raising sufficient funds from the scheduled banks and retiring some of their borrowings from the SBP in Q2FY14. This, together with declining foreign exchange reserves, has kept the market liquidity conditions tight and at times volatile. The result is that short term market interest rates remain on the higher side compared to increases in the policy rate.
The positive sign has been on the credit off take and willingness of banks for advances at the back of reduction in the policy rate as compared to previous years. During the first five months of current fiscal year private businesses borrowed Rs161 billion of which Ps38 billion is for fixed investment, compared to Ps16 billion in the corresponding period of last year. Substantial credit off take was seen in sectors such as textiles, electricity, gas, and water and commerce and trade. The positive of the economy is such where almost every sector of the economy is showing signs of growth. Growth in the manufacturing sector will result in high credit off take further improving the advances and net NPLs to net loans ratio. Growth in the economy will be a positive for job creation.
Pakistan has always been a net importer. With revaluation of exchange rate, the gap between imports and exports is expected to widen. Trade deficit has been hovering around 6.5 percent of GDP on average for the past five years. It is expected to increase to 7 percent of GDP or USD 17.1 billion in FY14 despite a projected increase of 6 percent in export receipts that includes the impact of recently approved GSP Plus status accorded to Pakistani exports by European Union.
Due to increase in trade and business, import payments are also expected to grow around 8 percent. Worker remittances are expected to average more than US1 billion a month with a steady increase. Coupled with auction of 3G licenses, inflows from IMF, the external current account deficit for FY14 is projected to remain in the range of 1.0 to 1.8 percent of GDP. International commodity prices, especially those imported by Pakistan, have either remained stable or declined since the beginning of FY14. This has neutralized to some extent the direct impact of exchange rate volatility on CPI inflation. Sharp increase in year-on-year CPI inflation during H1 FY14 is recorded at 5.9 percent in June 2013 to 9.2 percent in December 2013, is primarily due to domestic factors. Increase in cost of utility including fuel, gas and electricity has resulted in an increase in inflation. Furthermore, with revaluation, one would have expected fuel prices to reduce by at least 10 percent which has not been done.
According to the Monetary Policy Statement of January 2014, Energy (NFNE) inflation was 8.2 percent in December 2013; marginally up from 7.8 percent in June 2013. This is because economic activity has remained quite sluggish over the past few years. It will take some time before expected pickup in economic growth pushes up aggregate demand. SBP expects average CPI inflation for FY14 to fall between 10 to 11 percent, which would be higher than the target of 8 percent announced by the government. The reason for recent increases in the policy rate was also to manage expectations in the wake of expected inflation remaining higher than the target and restrict decline in real interest rates. The government since the previous budget has increased taxes. General Sales Tax (GST) has had a major impact on prices especially on food items. According to SBP, fiscal measures have adversely affected inflation outlook for FY14 which will in turn help reduce budgetary borrowings from the banking system and thus inflationary pressures in the medium term. For FY14, the government has announced a fiscal deficit target of 6.3 percent of GDP and managed to contain it at 1.1 percent of GDP during Q1FY14. This is a positive start that needs to continue. Key risk to the fiscal position is a possible shortfall in tax revenues, recurrence of energy sector circular debt, and delays in budgeted foreign inflows. Such deviations could lead to increase in borrowings from the banking system, further accumulation of domestic debt and higher inflation.
SBP reserves are down to US4.6 billion which needs to be filled. Pakistan recently received US$1.5 billion through Pakistan Development Fund and US$0.3 billion in Collation Support Fund. Expected IMF inflows of US$0.5 billion are expected before June 2014. The PRI scheme primarily being pushed by large banks is expected to make a difference. The privatization initiative of the government, if able to attract foreign buyers is also expected to add to the reserve position. With pressure on reserves, it is expected that the government will continue to fill the gap through external debt, which will keep adding pressure on the reserve position when it comes to payments. We know that the revaluation had no direct correlation with economic indicators, therefore it is hard to predict where the currency will be as decisions behind closed doors of the government are unknown. The country needs “friendly flows” to help support the reserve and payment position. With widening of the trade deficit, it is unlikely that the devaluation will not occur in the future.