Financial Risk Manager

1. A relative decline in average CPI inflation compared to earlier projections and a gradual buildup of foreign exchange reserves provide a modicum of macroeconomic stability as the economy begins a new fiscal year. These developments appear more pronounced in the backdrop of devastating floods of early FY11 and a significant shortfall in external financial inflows. While the containment of government borrowings from SBP in H2-FY11 played its part in relatively improving the inflation outlook, a substantial increase in export prices and steadily rising remittances facilitated the reserve accumulation. A cumulative increase of 150 basis points in SBP’s policy rate during H1-FY11 and a proactive management of financial markets also helped in realizing these incremental gains.

2. A lower than projected inflation does not provide an enduring source of comfort for SBP as it continues to show a high degree of persistence at an elevated level. The 12-month moving average of CPI inflation was 13.9 percent in June 2011, exactly the same level observed in every subsequent month since December 2010, and 4.4 percentage points higher than the target for FY11. This level of inflation is not limited to the prices of few items and is in fact quite broad based, indicating that expectations of inflation are fairly entrenched in the economy. Thus, a meaningful reduction in inflation would require consistent and credible implementation of monetary and fiscal policies.

3. Acknowledging the persistence of inflation, the government has announced an inflation target of 12 percent for FY12. The government has also provided in the Medium Term Budgetary Framework (MTBF) a desired path of inflation of 9.5 percent and 8 percent for the subsequent two years. Conditional upon factors such as adjustments in the administered prices of electricity and oil and a projected broad money (M2) growth of 15 to 16 percent SBP’s forecast of average inflation ranges between 11 and 12 percent during FY12.

4. A close inspection of the overall expansion in monetary aggregates and their changing composition is important to understand both the moderate decline and persistence of inflation. For instance, reserve money grew by 17.1 percent in FY11 with 82 percent of the expansion coming from an increase in the Net foreign Assets (NFA) of SBP. Accumulation in NFA is a reflection of the external current account surplus and build-up of reserves by the SBP. A surplus in the external current account, in turn, is an indication of somewhat restrained aggregate demand in the economy and therefore relative stability in inflation, albeit at a high level. Retirement of government borrowings from SBP towards the end of both the third and fourth quarter of FY11 has also been helpful in improving the inflation outlook.

5. The government borrowing from scheduled banks, however, has increased substantially. It grew by 74.5 percent in FY11 and contributed 65 percent to the 15.9 percent growth in broad money (M2). The growth in private sector credit, on the other hand, was only 4 percent with negligible demand for fixed investment. These monetary trends show that the decline in aggregate demand is less than desirable and expansion in productive capacity of the economy remains weak. Both these factors help understand the persistence of inflation. The falling productivity due to severe energy shortages and deteriorating law and order conditions together with unanticipated and sporadic adjustments in the administered prices are also adding inertia to inflation.

6. The borrowing needs of the government from the scheduled banks were mostly met through short term instruments. This has increased the rollover requirements substantially and has complicated liquidity management. Apart from mitigating the resulting volatility in the money market overnight repo rate and keeping it consistent with the monetary policy stance, SBP’s liquidity operations had to strike a difficult balance among multiple and competing considerations. These include stability of the payments system, adequate availability of liquidity in the market, and build up of foreign exchange reserves.

7. The underlying reasons of growing government borrowings are structural and not specific to FY11 though it must be acknowledged that FY11 was a difficult year given floods and other pressing spending needs. The consolidated fiscal data has not been released, however, provisional estimates from the financing side indicate that the fiscal deficit in FY11 may have reached close to Rs1127 billion or 6.2 percent of GDP. Excluding the one-off payment of Rs120 billion to partially settle the circular debt in the energy sector, the fiscal deficit in FY11 comes down to 5.6 percent of GDP.

8. The main structural weaknesses causing this high level of fiscal deficit and a rise in total debt are low tax to GDP ratio and rigid current expenditures. While exemptions and ineffective taxation of major parts of income generating sectors of the economy are limiting the revenue generation capacity, continued provision of financial support to the loss making Public Sector Enterprises (PSEs) and untargeted subsidies are keeping the current expenditures under pressure. Consequently, the tax to GDP ratio remains low, 8.6 percent in FY11, and any fiscal adjustment inevitably results in cuts in the development expenditures, which is not desirable given the infrastructure needs of the economy.

9. These considerations underscore the need to accelerate the implementation of fiscal reforms currently being considered by the government. A path of fiscal deficit in the next three fiscal years has been provided in the Medium Term Budgetary Framework (MTBF), which shows a budget deficit target of 4 percent for FY12. Moreover, the government is planning to reduce the revenue deficit to zero in FY12 with a projected surplus in the following two years. This assumes an ambitious increase in tax collection by the Federal Board of Revenue (FBR). An effective implementation of fiscal reforms, especially those related to broadening of the tax base, and better coordination with the provinces are urgently required to implement this plan.

10. Unlike fiscal accounts the position of the external current account improved considerably in FY11 and contrary to earlier projections a surplus of $542 million has been realized. A significant and unexpected growth of 29.4 percent in exports and a robust growth in workers’ remittances, which now stand at $11.2 billion, are the primary factors responsible for this improvement. Fragile global economic conditions and dominance of price effect in both exports and imports, which was more pronounced in H2-FY11, has increased exposure of the economy to movements in international commodity prices.

11. Incorporating the recent declining trend in international cotton prices and likely continuation of international oil prices around $100 per barrel, projected growth rate of exports is 6 to 7 percent and that of imports is 10.5 to 11.5 percent. The external current account is expected to show a modest deficit of 0.8 percent of GDP in FY12. Given an increase in debt obligations and continued suspension of IMF’s Stand-By Arrangement (SBA) financing even a small external current account deficit could pose challenges in terms of maintaining an upward trajectory of SBP’s foreign exchange reserves.

12. The main risk in external accounts emanates from the declining capital and financial flows, which have dropped to $1.8 billion in FY11 from $5.3 billion in FY10. The perceived high country risk, relative to other emerging market economies, is the main factor underlying the reluctance of private foreign investors to invest in the country. The delays in implementation of economic reforms, on the other hand, resulted in shortfalls in estimated foreign loans. Nonetheless, by end-June 2011, SBP’s liquid foreign exchange reserves have increased to $14.8 billion from $13.0 billion at end-June 2010. A reflection of an improved overall external position can also be seen in a relatively stable exchange rate; Pak rupee marginally depreciated by 0.5 percent against the US dollar in FY11.

13. The provisional National Income Accounts, however, do not share the positive aspects of external accounts. The devastating floods at the start of FY11 were a serious setback for economic growth in the economy already beset by continuing energy shortages and deteriorating law and order conditions. As a result, real GDP growth of 2.4 percent fell short of the target by more than 2 percentage points. The main casualty was the real private investment expenditures. The gross fixed capital formation by the private sector contracted by 3.1 percent, leading to a decline in total gross investment to 13.4 percent of GDP; the lowest level since FY74. However, due to strong growth in real consumption expenditures, aggregate domestic demand grew by 5.9 percent.

14. At the same time, national savings have increased to 13.8 percent of GDP, mainly due to net factor income from abroad. Consequently, the gap between national savings and investment as a percent of GDP has turned marginally positive. Since this positive gap is mostly due to falling investment, it cannot be considered as an encouraging development from the perspective of reviving economic activities and sustaining high growth over the medium term.

15. Against this backdrop, SBP has decided to reduce the policy rate by 50 basis points to 13.5 percent effective 1st August 2011. The key parameter in this assessment is the outlook of inflation that indicates that average inflation in FY12 is expected to remain in line with the announced target. No adjustment in the interest rate would have entailed further tightening of monetary policy in real terms, which is not warranted given the decline in private investment. Moreover, despite fiscal slippages, the government has adhered to restricting the stock of its borrowings from SBP to Rs1155 billion (on cash basis). In fact, the government retired these borrowings compared to both the end-June 2010 level as well as the mutually agreed limit of end-September 2010 level. The government has also expressed its commitment to continue with a stance of zero borrowings from SBP in yearly flow terms in FY12, which bodes well for anchoring inflation expectations. However, the developments related to expected financial inflows and pattern of government borrowings from scheduled banks will need to be monitored closely to assess potential risks for macroeconomic stability.