October 31, 2019 (MLN): The State Bank of Pakistan recently released a comprehensive report on the state of economy, which also provided some insight regarding the Monetary Policy and Inflation.
According to the report, the monetary policy environment remained challenging throughout FY19, as macroeconomic stress manifested in rising core and headline inflation, low level of foreign exchange reserves and large twin deficits – continued to persist despite policy measures taken last year.
While the economy was already bracing for a policy-led slowdown along with a more flexible exchange rate regime, it also had to put up with speculations with respect to the decision on the IMF program. Moreover, to comply with international regulatory standards and also to broaden the tax base, the government scaled up its documentation efforts and tightened financial scrutiny.
All of this weakened the confidence of businesses and consumers, which sparked volatility in currency and equity markets, increased cash penetration in the economy, and slowed down deposit mobilization in the banking system.
While the ongoing structural measures will take some time to settle down before financial markets and businesses could stabilize and firmly reposition, the SBP continued to maintain tight monetary conditions to manage demand and anchor inflation expectations.
The SBP’s monetary policy committee (MPC) increased the policy rate in all six decisions during the year, by a cumulative 575 bps. The foremost concern was the steady increase in headline inflation. Here, the impact of demand overhang was exacerbated by rising cost pressures in the economy, as the government pushed up administered energy prices in an attempt to limit its current expenses amid growing fiscal constraints. Not only did this escalate inflation in the energy and transport components of the CPI basket, but it also had a spillover impact on other food and non-food items.
A similar pressure came from the pass-through of the ongoing, as well as the earlier, depreciation of Pak rupee on prices of imported goods, and goods with heavy imported content. Making things worse, food inflation rose steeply during the 4th quarter, which reflected weaknesses in the intervention mechanism and monitoring system in wheat and sugar markets, and the absence of an immediate contingency plan to cope with crop damages and disruptions in the distribution chains.
As a result, the inflation outlook, which already projected a higher-than-target outcome at the start of the year, became more challenging through the course of it. The persistence of large twin deficits did not help either; in fact, this triggered significant upside risks to the near-to-medium term inflation outlook.
Specifically, although import compression measures helped bring down FX payment pressure in the economy, the official foreign exchange reserves remained below the standard adequacy level (3-month import cover). This led the Pak rupee to depreciate at frequent intervals.
On the fiscal front, a sharp rise in current spending and a slowdown in revenue collection more than offset the impact of the cut in PSDP. The resultant higher deficit ran the risk of diluting the impact of consolidation efforts, especially when its financing was increasingly made by borrowings from the SBP.
Nonetheless, the combined impact of a decline in PSDP spending, the depreciation of Pak rupee, and other regulatory and administrative measures was significantly noted on private consumption and investment. The efforts specifically dented activities in the industrial sector, which typically generates nearly 61 percent of businesses’ credit demand.
Surprisingly though, the offtake of private credit was quite upbeat in the first half of the year, despite the fact that the LSM activity had begun to fall since the beginning of FY19. This trend can be explained by heavy borrowings by export-oriented industries for working capital during the period, as interest rates under the SBP’s subsidized loan schemes (already at historic low levels) have been kept unchanged.
Although cost pressures persisted in the later months of the year, the overall credit momentum weakened significantly as the economic slowdown deepened and steadily spread across a number of sectors. For the full year, the private credit offtake posted a growth of 11.6 percent in FY19 compared to 14.9 percent last year. However, after adjusting with movements in the WPI index, the offtake in overall private credit this year was much subdued.
With the cost-driven momentum in private credit and heavy fiscal borrowings, the overall growth in money supply in FY19 was higher than last year. Furthermore, the composition of M2 growth remained heavily skewed towards public sector borrowings, which implies that fiscal discipline needs to be maintained to enhance effectiveness of monetary policy tightening. This is going to be a complex task going forward, given the fact that the outsized stock of government’s domestic debt has already been repriced following the steep rise in the policy rate: in FY20, the government has estimated its mark-up expense to increase by 45.5 percent compared to FY19, eating up more than half of the FBR’s estimated tax revenues.
Under these circumstances, effective implementation of monetary policy will hinge upon management of the primary balance, and commercial banks’ portfolio choice. As for the government, it has set a much lower target for the primary deficit next year under the IMF program; committed not to take additional budgetary financing from SBP; and devised a plan to gradually reduce the existing outstanding stock of debt held by the central bank.
Furthermore, to address unwarranted liquidity requirements, the government has recently approved the Cash Management and Single Treasury Account Policy 2019-2029. These measures are expected to contribute positively towards monetary policy transmission going forward.
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