Macroeconomic conditions weaken during H1-FY13 despite improvement in key indicators

Macroeconomic conditions weaken during H1-FY13 despite improvement in key indicators


Karachi, February 08, 2013 (PPI-OT): The macroeconomic conditions weakened during H1-FY13 despite improvement in some key indicators. The CPI inflation came down quite sharply till November 2012 but has increased since then. The external current account posted a surplus during H1-FY13 but the foreign exchange reserves have declined, predominantly due to IMF repayments. The non tax revenues of the government received a boost after receiving Coalition Support Fund (CSF) of 0.7 percent of GDP during H1-FY13 yet the fiscal deficit is expected to miss the budgeted target by a wide margin.

Nonetheless, the SBP did respond to a sharply declining inflation and, assigning a higher weight to contracting private investment, lowered its policy rate by a cumulative 450 basis point over the last 18 months. It has also ensured that both the money and the foreign exchange markets remain stable. Further, the SBP has introduced certain measures to improve the liquidity management and financial intermediation aspects of the banking sector.

In the wake of rising risks to macroeconomic stability and in the absence of structural reforms that could have supported price stability and growth in medium term, it may be difficult to continue with the same monetary policy stance. The SBP has to be forward looking and take steps to meet the emerging challenges. The two main challenges, from the point of view of SBP, are managing the balance of payment position and containing the resurgence of inflationary pressures.

The fundamental weakness in the balance of payments is the continuous decline in the net capital and financial flows. There has been a net outflow of $539 million in this account during H1-FY13. In addition, the SBP has retired $1.4 billion of IMF loans during the first seven months of FY13. Thus, despite an external current account surplus of $250 million in H1-FY13, the foreign exchange reserves of SBP have declined to $8.7 billion as on 31st January 2013 from $10.8 billion at end-June 2012.

The surplus in the external current account during H1-FY13 was primarily due to the receipt of $1.8 billion in the CSF. Marginal improvement in the trade balance and robust growth in workers’ remittances have also helped the external current account balance, mitigating the pressure on the balance of payments position.

The SBP expects the external current account deficit to remain below 1 percent of GDP for FY13. This is despite little expectation of receiving proceeds of approximately $850 million from the auction of 3G licence.

However, given the declining trend in financial inflows and a very low probability of receiving the budgeted privatization inflows of $800 million in FY13, the challenges on the balance of payments position are unlikely to subside. Further payments of $1.6 billion of IMF loan in the remaining five months of FY13 and $3.2 billion in FY14 do not help the situation either. While the economy has sufficient reserves to meet its debt obligations, the real challenge is to manage the market driven sentiments.

Volatility in the foreign exchange market can have implications for the inflation outlook due to potential feedback from exchange rate changes under prevailing conditions. This is why the SBP has intervened in the foreign exchange market in a calibrated manner to ensure its smooth functioning. It is important to remember that only a consistent increase in foreign exchange can ensure stability in the market.

Additionally, high growth in monetary aggregates and upward adjustments in administered prices are the major risks to medium term inflation outlook. The recent trend in international oil prices is also on the higher side. The CPI inflation has already risen in the past two months; from 6.9 percent in November 2012 to 8.1 percent in January 2013. The core inflation measures are also inching towards double digit figures again after coming down to single digits.

While this reversal in inflationary trend is not surprising and was anticipated by the SBP, the average inflation for FY13 is projected to remain between 8 and 9 percent; well within the target of 9.5 percent. It is the medium term inflation outlook that needs to be assessed carefully. A rising trend in monetary aggregates is a key indicator of medium term inflationary pressures.

The SBP expects M2 growth for FY13 to be close to 16 percent. Similarly, due to a weakening external position and rising debt levels in the economy, anchoring expectations of inflation at low levels would be a challenging task.

The behavior of monetary aggregates is primarily driven by fiscal borrowings from the banking system. As on 25th January 2013, the year-on-year growth in M2 was 17.3 percent while that in fiscal borrowings from the scheduled banks was 41.3 percent. It is worth highlighting that over the last four years fiscal borrowings from the scheduled banks for budgetary support have grown by an average of around 60 percent.

The average growth in credit to private businesses, on the other hand, has only been 4 percent during the same period. The end result is that the domestic debt has risen by 25.6 percent on average while private fixed investment has contracted by 9.4 percent in the economy.

Although the deposits of the banking system show a growth of 17.4 percent, however, given the substantial fiscal requirements, the SBP had to continuously rollover significant amounts of liquidity injections.

The average amount of these injections, during 1st July – 7th February FY13 was Rs498 billion and has been the driving force behind a year-on-year growth in reserve money of 15.3 percent. Since inflation had been coming down during H1-FY13, these high level of injections did not pose an immediate risk. A rising inflationary trend, however, would require containment in budgetary financing and a gradual scale back in the size of these injections.

While the fiscal authority did manage to retire its borrowing from the SBP in the first quarter of the current fiscal year, it was unsuccessful in the second quarter due to inherent structural weaknesses of the fiscal position. Specifically, it retired Rs399 billion in Q1-FY13 and borrowed Rs183 billion in Q2-FY13 from the SBP. The inability to keep these borrowings at zero within a quarter is a contravention of the SBP Act and an important factor behind an imperfect control over inflation expectations by the SBP.

The growth in credit to private businesses, which is a part of overall private sector credit, has been higher during H1-FY13 compared to the corresponding period of last year. In flow terms private businesses availed Rs154 billion during H1-FY13 as opposed to only Rs85 billion during H1-FY12.

This could be because of declining interest rates and moderation in accumulation of Non Performing Loans (NPLs). Since the beginning of FY13, the average lending rate has decreased by 204 basis points to 11.3 percent in December 2012. Similarly, the NPLs to advances ratio has declined to 15.5 percent in September 2012 from 16.7 percent in September 2011.

However, this increased flow of credit to private businesses is not sufficient to have a sustainable investment led growth in the economy. With contracting private fixed investment expenditures and a fragile global economy, the GDP growth in Pakistan will be essentially consumption-led and is expected to remain just below 4 percent in FY13.

The fundamental reasons for this likely outcome are the prolonged and severe crisis in the energy sector and worsening law and order conditions in the country. These constraints are not only causing substantial under-utilization of the installed productive capacity but also discouraging potential private sector investment.

The substantial fiscal borrowing pressures are not providing any breathing space to the private sector either. The main reason for large borrowing requirements from the banking system is the structurally high fiscal deficit, though low external financing is also adding to the problem. The estimates from the financing side of fiscal accounts indicate a deficit of 2.7 percent of GDP during H1-FY13.

This is despite receiving 0.7 percent of GDP of non tax revenues in the shape of CSF flows. Given a low growth of 8.8 percent in the tax collection of the FBR during the first five months of the current fiscal year, which is substantially below target, and the continuation of subsidies related to the energy sector, the budgeted fiscal deficit target of 4.7 percent of GDP for FY13 is projected to be missed by a wide margin.

The sources of consistently high fiscal deficit are well known – low tax base and evasion together with subsidies to the loss making Public Sector Enterprises (PSEs) and the energy sector. Due to a continuous increase in short term borrowings at a very rapid pace, the share of interest payments in current expenditures has also risen quite sharply in the last few years. Thus, comprehensive initiatives are required to make the fiscal position sustainable and restore macroeconomic stability.

In view of macroeconomic conditions discussed above, the Central Board of Directors of SBP has decided to maintain the policy rate at the existing level of 9.5 percent. However, with the objective of improving transmission mechanism by minimizing short-term volatility in interest rates and to bring more transparency, existing width of the interest rate corridor is being reduced from 300bps to 250bps.

For more information, contact:
Syed Wasimuddin
Chief Spokesman
State Bank of Pakistan (SBP)
Tel: +9221 3921 2562
Fax: +9221 3921 2563



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