The State Bank of Pakistan (SBP) may hike discount rate by a further 100 basis points (bps) in the current fiscal year (starting in July 2010), taking the overnight deposit and lending rates to 11 percent and 14 percent, respectively.
“SBP has hiked rates in an attempt to pre-empt the deterioration in the FX reserves position and to support a stable Pakistani rupee,” said an economist at Standard Chartered Bank (Pakistan) Limited, Sayem Ali. The SBP raised policy rates by 50bps on 30 July in a pre-emptive move to counter inflationary pressures. The rate hike surprised.
The markets, given the decline in headline inflation and the strengthening of FX reserves to record levels since the last policy meeting in May 2010. The hawkish tone of the policy statement indicates that the SBP sees inflation posing a significant challenge ahead and stands ready to raise rates further. This makes additional hikes likely, given the government’s expansionary fiscal stance and strong possibility that it will miss key revenue and deficit targets.
The expansionary fiscal policy has also led to delays in the release of IMF funds, and the SBP has hinted that the critical FX aid flows are at risk, owing to government excesses. The bond market has turned bearish since the SBP hiked rates, with the benchmark 10Y bond rising 52bps to 13.5 percent, and expectations of further hikes will dominate market sentiment going forward. Private credit growth is non-existent and the economy is not experiencing any salary pressure. Higher interest rates are unlikely to have the desired impact on inflation unless they are accompanied by much-needed fiscal consolidation.
This looks highly unlikely, especially given the devastation caused by the recent heavy floods and the additional costs of reconstruction and rehabilitation work. Hence, we see the SBP hiking rates by another 100bps in the current fiscal year.
Inflation may rise further owing to hike in power tariffs and expansionary fiscal policy.
The SBP has warned that the risk of inflation remains high and forecasts inflation to average 12 percent in FY11, significantly higher than the government’s target of 9.5 percent. Headline inflation averaged 11.7 percent in FY10, significantly higher than the nine percent target, owing to a hike in power and gas tariffs, a severe energy crisis and government intervention in commodity markets.
The central bank warned that inflation would accelerate in FY11 due to “rising domestic demand relative to weak productive capacity”. The key concern is the expansionary fiscal policy, with the SBP projecting the government deficit at five percent of GDP in FY11 versus the budget target of four percent.
Measures announced in the FY11 budget, including further adjustments in power tariffs, an increase in the general sales tax (GST) rate, and a 50 percent hike in government employees’ salaries, have increased the risk of higher inflation going forward.
Pakistan’s worst-ever floods, following heavy monsoon rains, which have left more than three million people without food or shelter, have exacerbated the situation. The damage to crops, supply disruption of essential food commodities and the impact of reconstruction and rehabilitation costs on government finances have significantly increased inflation risks. In our view, CPI inflation will accelerate to 13.6 percent y/y in H2-2010 from 13 percent in H1.
Fiscal vulnerabilities increase inflation risks: The government’s expansionary fiscal stance has diluted the impact of tight monetary policy and continued to fuel inflation. The FY10 deficit increased sharply to 6.2 percent of GDP, versus the revised target of 5.1 percent agreed with IMF staff in May 2010. High debt-servicing costs and spending on military operations in the north, combined with weak tax collection; have led to the wider deficit. The SBP has warned that the build-up of public debt, which has ballooned to 60.3 percent of GDP in FY10 from 58.4 percent of GDP in FY08, is unsustainable, and the high cost of servicing the debt will pose a challenge over the medium term.
Critical tax reforms, such as the introduction of VAT – which are needed to reduce the high fiscal deficit and the build-up of debt – have been delayed, raising concerns about inflation and the government’s ability to meet its FY11 budget targets.
The SBP indicated that the fiscal deficit in FY11 will remain above five percent of GDP, against the budget target of four percent of GDP, owing to higher provincial spending. The deficit could be revised even higher, given the likely shortfall in tax revenue targets and uncertainty regarding the timing of external financing from the US government and other donor agencies. The additional costs of reconstruction and rehabilitation of local communities following the worst-ever floods in various parts of the country will represent an additional burden on government finances.
The large fiscal deficits are being financed through heavy borrowing from the central bank by printing new money, fuelling inflation. During the first two weeks of the current fiscal year, the government printed Rs 65 billion for deficit financing, compared with Rs 44 billion for the whole of FY10, indicating that government finances remain in poor shape.
The SBP has warned that the expansionary fiscal stance is “inconsistent” with the objectives of macroeconomic stability, and has “contributed towards aggravating expectations of rising inflation” and kept upward pressure on interest rates.
Unless the government turns around the performance in the near term, by increasing tax revenue and curtailing nonessential spending, inflation will remain high and is likely to lead to further rate hikes.
C/A deficit projected to increase sharply, IMF funds at risk: The central bank also warned that the sustainability of external accounts improvement and the build-up of FX reserves “faces headwinds” in FY11. The current account (C/A) deficit is projected to widen sharply in the current fiscal year to USD 7.3bn (3.7 percent of GDP), from USD 3.5bn (2 percent of GDP) in FY10, owing to an expected pick-up in import demand and a recovery in international commodity prices. While the SBP is forecasting robust seven percent export growth, the C/A is projected to widen, mainly because of a 12 percent increase in the import bill. Large external debt payments, declining FDI inflows and a widening trade deficit threaten the build-up of FX reserves, which increased to a new record of USD 16.7bn (5.1 months’ of import cover) in June 2010, from USD 12.5bn in June 2009.
The build-up of FX reserves has been primarily supported by the release of the IMF funds, and the SBP has indicated that the fiscal slippage has put at risk the large FX aid flows expected from the IMF and other multilateral agencies. The $11.3 billion Stand-By Arrangement (SBA) ends in December 2010, and the government has approached the IMF for a new loan facility to support the medium-term balance of payments. However, unless major corrective measures are taken to improve the fiscal position, including measures to increase tax revenues, the IMF loans cannot be taken for granted.