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A smart move

The monetary policy decision boiled down to a trade-off between lower inflation and Balance of Payments woes. Reportedly the Monetary Policy Committee was split in its decision and the central board eventually decided to cut the rate by 50 basis points. Had the government not increased GST by one percent, besides its pledge to raise electricity tariffs; the rate cut may have been more pronounced.

A source privy to the decision on the policy rate confided that in case these two considerations had not stoked fears of inflation in coming weeks, the discount rate may well have been slashed to 8.5 percent. The tone of the monetary policy is dovish and it seems that despite the fact that SBP held foreign exchange reserves are down to $6.2 billion (2 months of imports), the central bank is not perturbed by fears of dollarization. The reading between the lines is that the central bank is convinced that the Government of Pakistan will once again be joining an IMF Programme soon and that will provide cushion to the Balance of Payments.

SBP has been focusing on keeping real interest rates in the vicinity of zero for the past few years and that is precisely why it had maintained a hawkish stance during 2009-11. In line with that approach, the current rate cut seems logical as inflation was about two percentage points below the interest rates.

But the government had borrowed Rs 1,230 billion from the banking sector including Rs 413 billion from SBP to feed its fiscal appetite, hence the chances of demand-pull inflation are high. Also, supply-push factors like increased GST and electricity tariff rationalisation are looming.

That restricts SBP to keep real interest rates in positive territory. Yet private sector credit off take remained muted while the real GDP growth has been limited to 3.6 percent against the target of 4.3 percent. Similarly, private fixed capital formation has decreased by 1.8 percent – the fifth consecutive year of declining trend, asserted SBP. But with the change in the political climate, there is a change in sentiments and that could result in some private sector financial inflows going forward. Plus declining inflation has increased relative real returns on the rupee-denominated assets.

This provided some room to lower nominal rates despite of Balance of Payments concerns, emphasised the central bank. In the end it was the fiscal woes that kept SBP cautious. As the fiscal deficit in the outgoing year is touching 8.8 percent of GDP and is budgeted at 6.3 percent in FY14.

On the other hand, the current account appears manageable with a deficit of just one percent of GDP in the outgoing year. Given these factors, the decision on setting the direction for monetary policy could not have been an easy one and that is why economists at SBP were cautious about risks of dollarization and further fall in foreign reserves. But in the end the ball landed in the court of the Board of Directors which is dominated by government officials. The government”s domestic debt stands about Rs 10 trillion, making it the biggest beneficiary of any lowering in the cost of funds. That consideration apparently reigned supreme in the minds of the Directors on Friday.

The decision will also sit well with the business community; ardent supporters of the PML-N. By the time the next MPS decision is to be announced, the IMF Programme will probably have commenced necessitating a tougher line from the central bank as well. So while the economists sat scratching their heads over the inflation versus BoP conundrum, in the end the politically astute decision was made; bringing smiles to politicians and businessmen alike.

Ali Khizar Aslam, "A smart move," Business recorder. 2013-06-22.
Keywords: Social sciences , Monetary policy , Central bank , Government-Pakistan , Political system , Economists , Business community , Politicians , Electricity , Pakistan , IMF