Inflation poses big challenge: SBP

KARACHI - The State Bank of Pakistan kept the key policy rate for the next two months unchanged at 14 percent on Saturday, but urged more fiscal discipline in order to put a check on inflationary pressures. After incorporating the improved external position SBP has decided to keep the policy rate unchanged at 14 percent, the SBP said, adding that the fiscal deficit needed to be contained. This was the third consecutive time the SBP left its key policy rate flat at 14 percent. The government is mindful of fiscal pressures and has expressed its resolve to address these issues, especially the containment of the fiscal deficit, the SBP said while announcing the monetary policy. It said weak economic growth, private investment and a large budget deficit still remain key challenges for macroeconomic stability in the shape of persistent inflation. In such circumstances, SBP is endeavouring to strike a delicate balance to address the multiplicity of considerations in formulating the monetary policy stance such as containing inflation, promoting private economic activity and keeping financial markets stable, the central bank said in a monetary policy decision, which was taken after its Central Board of Directors meeting held under the chairmanship of SBP Governor Shahid H Kardar in Karachi on Friday. The SBP said a 12-month average of 20 percent trimmed measure of core inflation has continued to move between 11.5 and 12.5 percent during last year. Nonetheless, the average CPI inflation for FY11 is likely to remain between 14 and 14.5 percent, which is lower than SBPs earlier projections, it said. The SBP predicted that countrys exports would exceed $25 billion by the end of FY11 in anticipation of a spectacular rise in international cotton prices. According to the SBP monetary policy document, the year-on-year growth in both reserve money and M2 remains close to 15.5 percent and may increase further by the end of FY11, which would be higher than SBPs earlier projections. The magnitude of such borrowings poses a challenge for effective liquidity management with implications for inflation in FY12. For the economy to grow on sustainable basis, the debt burden to become manageable and inflation to come down to single digit, the private productive activity and investment will have to increase considerably and quickly. Moreover, the government needs to decrease its borrowing from the banking system in order to create space for private sector credit, it stated. A careful analysis of Pakistans current economic conditions reveals a mixed situation. Led by strong export earnings and robust growth in remittances, the external current account position has surpassed all earlier projections. This has helped the SBP in building foreign exchange reserves and accumulating Net Foreign Assets (NFA), which contributed in keeping the foreign exchange market stable and provided rupee liquidity in the system, it mentioned. The remarkable improvement in the external current account, a surplus of $748 million during July-April, FY11, has been a major positive development. Given the turmoil in global economic conditions, especially in the export-destination and remittance-generating economies, there were expectations of an external current account deficit. This coupled with consistently rising inflow of remittances helped neutralise import and other payments. More importantly, despite falling financial account inflows, $0.5 billion during July-April FY11 compared to $3.7 billion in the corresponding period of last year, SBPs foreign exchange reserves have increased to $13.7 billion by 18th May, 2011 and are expected to increase further by end-June 2011, it projected. Barring any unforeseen developments, these factors together with the continued suspension of IMFs Stand-By Arrangement (SBA), which has implications for other financial inflows, imply that the stellar performance of the external account may be difficult to sustain. Therefore, maintaining the current upward trajectory of SBPs foreign exchange reserves would be a challenging task, it warned. The repercussions of uncertain foreign inflows may not be limited to the external sector. Deviations in the baseline estimates could affect the net external budgetary financing as well as the monetary projections, it mentioned. A similar scenario did play out in this fiscal year with implications for monetary management. For instance, government borrowing from the banking system has increased significantly due to shortfall in external financing, increase in fiscal deficit on account of security spending, unprecedented floods and the recent one-off adjustment of Rs120 billion to address the issue of 'old stock of the circular debt of the power sector. Incremental government borrowing during 1st July-7th May FY11 from the banking system, including SBP, for budgetary support was Rs614 billion; a year-on-year growth of 28.3 percent. The borrowings from SBP explain almost 80 percent of the expansion in reserve money while total banking system budgetary borrowings explain 95 percent of the expansion in M2, it revealed. Demonstrating its commitment the government retired its borrowings from the SBP in Q3-FY11 and by end-March 2011, bringing down the stock of these borrowings (on cash basis) to Rs1155 billion, it said, adding that the recent increase in these borrowings is temporary and a reflection of the governments efforts to internalise the growing quasi-fiscal expense related to the circular debt of the energy sector. The SBP has already shifted a portion of this borrowing, Rs61 billion, to the market through an outright Open Market Operation (OMO) and expects that government borrowing will soon converge on the end-September 2010 level, Rs1290 billion, as committed by the government. For a sustainable fiscal path, revenue-enhancing measures need to be complemented with renewed efforts to stem the leakages in the tax system, bring a wider range of incomes in the tax net, and effective expenditure control measures, especially the removal of subsidies. These initiatives will be critical for reducing the stress on the fiscal position and to encourage entrepreneurship in the economy, it advised.