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.

Following is the complete text of Monetary Policy decision announced by State Bank of Pakistan here on Monday.

The economy's ability to achieve sustainable recovery remains constrained owing to slow progress in the prevailing security and economic conditions. The key economic variables impeding stabilization and thereby growth are high and persistent inflation, continuing fiscal slippages and unresolved power sector issues. Whereas adjustments in administered prices of fuel and energy and the post-flood disruption in the supply chain of food items have contributed to the recent upsurge in inflation, the high level of government borrowing from the SBP is diluting the effectiveness of monetary policy in containing excessive monetary expansion and thus inflation.

The need for such borrowing is largely emanating from a seemingly difficult fiscal predicament. While rising security and flood-related expenditures and continued power sector subsidies are one aspect of the problem, a narrow tax base and a declining tax to GDP ratio are bigger issues magnifying the fiscal challenges. The cost to the economy is being paid through erosion in the purchasing power of the rupee, growing total debt, and discouragement of productive private sector activity.

High inflation, at a fundamental level, persists because of money creation in excess of productive activity in the economy.

Of the Rs 308 billion expansion in reserve money up till 19th November 2010 during the current fiscal year, Rs 266 billion is due to government borrowing from the SBP, which has been on an increasing trend since January 2010. Such borrowing has stoked expectations of increasing inflation, resulting in high interest rates. The nature of this fiscal expansion is the fundamental source of high inflation in Pakistan over the last year.

Increases in electricity and domestic petroleum prices and the impact of the catastrophic floods on food prices did play their part in providing impetus to CPI inflation but do not fully explain the persistence in inflation. Further, apprehensions that these supply shocks would dramatically worsen the inflation outlook have thus far not fully materialized.

Temporary price hikes in the food category, as seen in a monthly increase of over 5 percent during August and September 2010, have somewhat subsided. As a result, in Oct 2010, CPI inflation posted a marginal decline of 0.4 percent on year-on-year basis, while a 0.6 percent growth on month-on-month basis was well below the last 12 month's average.

On the other hand, the persistent component of inflation, proxied by core trimmed inflation, remains sticky at over 12.5 percent on year-on-year basis since January 2010 and has increased to a 1 percent monthly change in October 2010, with expectations of further increases. An important source of this stickiness is the expectations of a persistent reliance of the government on SBP to finance its deficit.

Indeed, the co-movement between persistence of inflation and that of government's financing gap is no coincidence. Therefore, it would be difficult to bring inflation down unless government borrowing from SBP is curtailed substantially and kept under control on a sustained basis.

Government borrowing from SBP at an increasing rate reflects severe fiscal vulnerabilities. Given the delays in the introduction of tax reforms and weak industrial production, the task of achieving close to 27 percent enhancement in tax revenues during FY11 is beginning to look quite ambitious.

For increasing its capacity to raise revenues and contain inflationary borrowings from SBP within an explicit and clearly defined limit, the government has shown its intention to: i)- widen the tax net through introduction of the Reformed General Sales Tax (RGST) along with other tax measures; ii)- effectively contain the power sector subsidies; and, iii)- amend the SBP Act, including explicit limits on government borrowings from SBP, which is now in the final stage of legislation.

Together, these could potentially address the problem in the medium term of stubbornly high inflation expectations, reduce the cost of borrowing, and hence pave the way for long term economic growth. However, it may take some time before the benefits of such important measures, after their implementation, begin to have their impact.

In the mean time, pressing flood-related expenditures and shortfalls in external financing of the budget have increased reliance of the government on domestic sources. The seasonal increase in the working capital credit requirements of the private sector during the second quarter is also higher on the margin due to higher input prices.

Consequently, pressure on the banking system and interest rates has increased. With low growth in the banking system Net Foreign Assets (NFA) and deposits, liquidity management has also become challenging. Therefore, to further encourage the private sector, fiscal authorities need to demonstrate greater resolve in implementing their strategy to contain the fiscal deficit through fundamental structural reforms and their commitment to restrict inflationary central bank borrowings. However, the recent rejection of the two PIB auctions in Q1-FY11 and acceptance of Rs 50 billion instead of the Rs90 billion offered by the banks in the 16th November 2010 T-bill auction is apparently inconsistent with the stated intentions.

Assuming a real GDP growth of 2.5 percent and that the expected decline in private and public sector investment expenditures would be largely compensated by increases in public sector consumption expenditures, the external current account deficit is likely to be narrower in FY11 than earlier projections of 3.5 percent. Helped by higher cotton prices, the export earnings of $7.1 billion during first four months of the current fiscal year seem fairly encouraging.

Similarly, the recent trends in remittances coupled with expectations of realization of Coalition Support Fund (CSF) receipts could prove to be quite helpful in meeting import and other payments. The real test, however, would continue to be in the financing of the external current account deficit. Assuming that the projected external official inflows for FY11 do materialize, a substantial growth in private foreign inflows would be required to maintain and build foreign exchange reserves.

Monetary policy is essentially a short term instrument with which emerging risks and uncertainties are managed. The impact of monetary policy on economic activity and inflation is indirect and operates with a lag, and unlike the case of fiscal policy that tends to be reactive, it has to be proactive.

Under the present circumstances, if the expansionary fiscal position is not expected to translate into a high external current account deficit during the current fiscal year then it could be the case that the private sector demand is muted. Therefore, the monetary policy stance could probably remain unchanged. However, inflation is rising and showing persistence because of relentless government borrowing from the SBP. The rising NDA to NFA ratio of SBP balance sheet and its strong association with CPI inflation also suggest that inflation is likely to persist at double digit levels during much of FY11 and possibly in FY12.

SBP's efforts to counterbalance the rapid expansion in reserve money and arrest the rising inflation expectations would require an increase in the policy rate. After careful consideration of this trade-off, SBP has decided to increase the policy rate by 50 basis points to 14 percent with effect from Nov. 30, 2010.

A principled decision has also been taken to strictly implement the revised limits on borrowings of the provinces from SBP, even if it involves stopping payments to the provincial governments. SBP believes that the entire responsibility of tackling macroeconomic problems has been unfairly placed on monetary policy only.

SBP also understands that the burden of this monetary tightening is being borne largely by the private sector, as it gets crowded out by the excesses of government borrowing for budgetary purposes and commodity operations, with all its adverse implications for sustainable economic growth.

A cursory look at key macroeconomic indicators shows substantial improvements on multiple fronts. Inflation (YoY) has fallen to 8.9 percent in October 2009 and is expected to remain in the vicinity of 11 percent by the end of current fiscal year. External current account has improved considerably, positively altering its projected trajectory. With government borrowings from the SBP remaining within the quarterly limits, the broad money (M2) has also remained contained along the projected path. The real sector is also showing signs of improvement as the large scale manufacturing (LSM) stage a recovery after a protracted declining phase. However, a close inspection of these encouraging developments together with a pragmatic assessment of prevailing security situation in the country and fiscal uncertainties invite caution and further analysis.

Recent month-on-month inflation changes in headline and core measures continue to be volatile and on the higher side, oscillating between 0.5 and 1.7 percent in case of the former and remaining stuck at 0.8 percent in case of the later. A reassuring fact is that the number of items in the CPI basket showing higher monthly increases relative to an historical benchmark has come down significantly. However, at the same time, the number of items displaying significant inflation persistence has also increased, which indicates the probable entrenchment of second round effects of inflationary process. The poor administration in the supply chain of some food items is not helpful either in positively altering inflation expectations. A higher than projected fiscal deficit for FY09 has also changed some underlying assumptions for inflation outlook in FY10. In addition, the full impact of electricity and gas price adjustments, a necessary part of fiscal consolidation measures, and recent resurgence of international commodity prices, on the back of early signs of global economic recovery, remains a source of uncertainty for inflation outlook.

Apart from influencing commodity prices, the recovering global economy is expected to revive global trade and flow of liquidity across borders, which bodes well for Pakistan’s exports and private financial flows. The recent strong inflow of workers’ remittances and a substantially improved external current account deficit of $1.1 billion in the first four months of FY10 may allow Pakistan’s economy to absorb the likely swelling of import bill induced by a nascent domestic recovery and higher international oil prices. However, the strength and sustainability of its overall balance of payments crucially depends on resumption of foreign financial flows.

Of these, portfolio inflows have picked up, direct investment has fallen, and official inflows, other than IMF, remain lower compared to projections. Looking forward, the magnitude and timing of expected non-IMF foreign inflows remain uncertain and could increase the challenges of SBP’s liquidity management and government’s budgetary financing.

Public sector’s steady borrowing requirements have the potential to raise the Net Domestic Assets (NDA) of the banking system. Though broadly respecting the pre-announced T-bill auction targets, Ministry of Finance (MoF) has realized Rs91 billion for budgetary support against maturities of Rs37 billion in the four auctions held so far in Q2-FY10.

Moreover, retirement of earlier borrowings for wheat procurement has been less than expected and to some extent neutralized by fresh borrowings for other commodities like rice, sugar, and fertilizer. Moreover, the credit availed by public sector enterprises continues to increase as well. Although the cumulative flow of credit to private sector during the first nineteen weeks of FY10 shows retirement of Rs3 billion, it has increased significantly in the past seven weeks (Rs92 billion).

This is in consonance with the improved performance of Large Scale Manufacturing (LSM) sector in the first two months of FY10; 0.5 percent growth compared to negative 5.7 percent in the corresponding period of last year. Given the expected improvement in supply of electricity and likely increase in global demand, private sector credit may increase further. Sustained increases in the private sector credit would depend on the extent of risk averseness by banks, scale of public sector’s pre-emption of limited funding sources, and fresh injection of liquidity through a gradual build up in NFA of the banking system. In conclusion, the overall level of risk and uncertainty in the economy has increased considerably given the present law and order situation. As a consequence, the pressure on the fiscal position, especially from the financing side, has escalated and growth in the real economy is limited. Striking a balance between monetary and financial stability and real economic activity has become increasingly difficult. In this perspective, SBP has decided to support the recovering real economic activity while keeping a very close watch on developments concerning the macroeconomic stability in the next two months. Therefore, effective 25th November, 2009, the SBP policy rate will be lowered by 50 bps to 12.5 percent.

Macroeconomic considerations and outlook that influence monetary policy decision depict a mix picture. While inflation (YoY) and balance of payment position has improved, fiscal and real sector performance remains tenuous. Domestic financial markets functioned adequately but lending to the private sector has remained subdued. From a forward looking perspective, expected improvement in the external current account and emerging global economic recovery augur well for Pakistan’s economy. But, limited progress on electricity shortages and stressed fiscal position dilute some of the optimism. Similarly, inflation outlook is not completely benign yet as depicted by recent monthly trends. Under these circumstances, assessment of balance of risks continues to be somewhat uncertain.

Both CPI and core inflation have declined further in August 2009, with former at 10.7percent and Non food Non energy (NFNE) measure of the latter at 12.6 percent on year-on-year basis. But, the pace of decline in inflation was less than expected. The monthly increase of over 1.5 percent in CPI inflation in the first two months of FY10 is still quite high and of concern. This monthly increase coupled with administrative issues in the supply chain of food items and projected increases in electricity prices to eliminate subsidies could have a bearing on the behaviour of domestic inflation in the coming months. Increase in international oil prices remains an underlying risk to inflation as well.

However, the likely presence of Ramadan seasonality in the CPI index, especially the food basket, and disproportionate contribution of only a few items calls for caution in interpreting recent monthly inflation indicators. Similarly, the effect of cost push shocks like electricity and oil on inflation may be neutralized by below capacity economic activity and slow aggregate demand. Moreover, expectations of inflation are likely to remain in check while the stabilization program remains on track. While it is likely that inflation will continue its secular decline, as observed in our last communication, there are risks to watch as we go forward.

Tapering aggregate demand pressures in the economy can be clearly seen in persistent and widespread decline in imports. Supported by continued strong inflow of worker’s remittances, this fall in import growth has resulted in a modest surplus of $82 million in the external current account for August 2009. Even the cumulative July-August, FY10 external current account deficit of $527 million is much lower than earlier projections.

Similarly, on the back of favourable revisions regarding outlook of Pakistan’s economy by international rating agencies, portfolio inflows are now positive; $55 million in the first two months of FY10. This, together with inflows from the IMF, both for budgetary support ($745 million) and allocation of increased Special Drawing Rights (around $1200 million), and adequate, though lower, foreign direct investments substantially improved the external financial account. Resultantly, the SBP’s foreign exchange reserves have increased to $10.9 billion as on 28th September, 2009 – an improvement of $1.8 billion since the beginning of FY10 – and is reflected in Rs123.6 billion increase in the Net Foreign Assets (NFA) during 1st July – 19th September, 2009. This has helped liquidity conditions in the economy and translated into bringing stability to the foreign exchange market.

This improvement in balance of payments is despite a significant shortfall in non-IMF official financial inflows. Non realization or shortfall in these official inflows could pose a potential problem for fiscal management, which faces significant pressure on both the expenditure and revenue side of the budget and has already posted a fiscal deficit of 5.2 percent of GDP for FY09 – 0.9 percentage points higher than the targeted level.

Provisional figure of Rs106.6 billion government borrowing from the SBP during 1st July – 19th September, FY10 also indicate the extent of fiscal position’s weakness in the current quarter. This borrowing was despite the fact that Ministry of Finance realized Rs333 billion in the six Q1-FY10 T-bill auctions while adhering to an advance auction target of Rs325 billion for the quarter. However, this financing pressure along with recent uptick in market interest rates and liquidity tightness is largely cyclical and is mostly due to the month of Ramadan and Eid festival. Likely reversal of these phenomena along with the retirement of wheat financing and improvement in external flows is expected to improve the market liquidity in the coming months and flow of credit to the private sector.

Sustainable recovery of real sector of the economy would not be possible without revival of business environment and availability of credit to private sector, which in turn depends on the elimination of electricity shortages among other factors. Moreover, stagnant private sector investment can hurt the potential output of the economy, adversely impacting inflation persistence. However, recent steps taken towards resolution of the circular debt issue could lead to the resumption of private sector credit in the coming months.

In conclusion, there are some risks to inflation while the economy gradually stabilizes. Moreover, uncertainty regarding the outcome of ongoing fiscal consolidation, resolution of electricity problem, and timing of official foreign inflows call for prudence at this point. Therefore, there will be no change in the SBP’s policy rate, which will remain at 13 percent. These issues are likely to determine SBP’s policy trajectory in the coming months.

Progressing further on the formation of the Monetary Policy Committee (MPC), Central Board of Directors of SBP has finalized the composition of this nine member committee. In addition to the Governor of the SBP, Syed Salim Raza, and Deputy Governor, Yaseen Anwar, three SBP executives – Riaz Riazuddin (economic advisor), Asad Qureshi (executive director, financial markets and reserve management), and Hamza Ali Malik (director, monetary policy department) – will be the internal members. Board of Directors of SBP will be represented by Mirza Qamar Beg and Tariq Sayeed Saigol while Hafiz Pasha and Shahid Kardar will join as external members. This committee will start its deliberations in November 2009. To harmonize the constitution of MPC with the legal framework of SBP and make it fully independent, amendments in the SBP Act have already been submitted for the legislative process. Until their enactment, the MPC will seek approval of its recommendations from the Board of Directors of the SBP.