Central Bank reduces policy rate by 50 basis points to nine percent

Yaseen Anwar, Governor SBP

By Mohammad Nazakat Ali

(Pakistan News & Features Services)

The State Bank of Pakistan (SBP) has decided to reduce the policy rate by 50 basis points to bring it down to 9 percent with effect from June 24, 2013.

This was decided by the Central Board of Directors of the State Bank of Pakistan at its meeting held under the chairmanship of SBP Governor, Yaseen Anwar, in Karachi on June 21.

According to the Monetary Policy Decision, the SBP has decided to place a higher weight to declining inflation and low private sector credit relative to risks to the balance of payments position.

Following is the complete text of the Monetary Policy decision:

“There has been a discernible positive change in sentiments post May 2013 elections because of clarity on the political front. The change in the behavior of banks in auctions of government securities and reaction of stock market are two examples. Importantly, there has been a considerable improvement in SBP conducted surveys of consumer confidence, expected economic conditions, and inflation expectations. The absence of foreign financial inflows and high fiscal borrowings from the banking system, however, remain formidable economic challenges, especially for monetary policy. Similarly, power shortages and security conditions continue to be strong impediments to growth.”

“An almost continuous and broad based deceleration in inflation over the last year has had a favorable impact on inflation outlook – a key variable in monetary policy decisions.  In May 2013, the year-on-year CPI inflation was 5.1 percent while trimmed measure of core inflation was 6.7 percent; the lowest levels since October 2009. The average CPI inflation for FY13 is expected to be at least two percentage points below the target of 9.5 percent.”

“However, in the latest budget the government has announced an increase of 1 percentage point in the General Sales Tax (GST), from 16 percent to 17 percent, and changes in the tax structure for some goods and services. In addition, the government is considering a phase-wise upward adjustment in electricity tariff. The exact magnitude and timing of this adjustment is yet to be decided. Therefore, there is a risk that average inflation for FY14 could exceed the announced target of 8 percent for the year. However, aggregate demand in the economy is expected to remain moderate, which could have a dampening effect on inflation.”

“A reflection of the current declining trend in inflation can be seen in the muted real economic activity, especially private investment expenditures. Beset by energy shortages and law and order conditions, the GDP growth has struggled to ameliorate in the last few years and this year was no exception. The provisional estimate of GDP growth for FY13 is 3.6 percent, which is lower than the 4.3 percent target for the year. Similarly, private fixed capital formation has decreased by 1.8 percent – the fifth consecutive year of a declining trend. Although there has been an encouraging uptick in the growth of Large Scale Manufacturing (LSM) sector, 4.8 percent in April 2013, it is too early to term it as an emerging trend.”

“A declining inflation trend and below potential GDP growth make a case for further reduction in the policy rate. The argument is twofold. First, the SBP has been giving a relatively high priority to inflation in its monetary policy decisions over the last few years. Thus, continuing to do so would indicate consistency in the monetary policy stance. Second, without further reduction in the policy rate, the real interest rate – policy rate minus expected inflation – would increase due to declining inflation. High real interest rates are not helpful for supporting private investment in the economy.”

“However, as indicated in the last monetary policy decision, the current balance of payments position and a structural imbalance in fiscal accounts suggest vigilance. The stress in the balance of payments position was a prime consideration in maintaining the policy rate at 9.5 percent in the last two monetary policy decisions. The basic argument has been that the return on rupee denominated assets needs to be sufficiently attractive to discourage speculative demand for dollars.”

“There is no significant revision in the assessment of the balance of payments position since the last monetary policy decision. The external current account deficit is expected to remain manageable, around 1 percent of GDP for FY13, signifying very low risk from this source for the external accounts. The real challenge continues to emanate from the lack of financial inflows. Let alone finance the small current account deficit, there has been a cumulative net capital and financial outflow of $143 million during the first eleven months of the current fiscal year. Add to this the on-going payments of IMF loans and it becomes clear that the pressure on foreign exchange reserves has not abated. As of 14th June 2013, SBP’s foreign exchange reserves stand at $6.2 billion.”

“There are two developments, however, that are worth highlighting. First, there has been a noticeable change in sentiments, as highlighted above, that can potentially have a favorable influence on private financial inflows. Other than the overall economic outlook, investment decisions do take into account the relative political certainty that determines the continuation of economic policies for some time in the future. Second, declining inflation has increased the relative real return on rupee denominated assets. This could provide some room for downward adjustment in nominal returns to cater to broad macroeconomic considerations despite external account concerns.”

“In this context, a lot depends on the fiscal outlook. The fiscal deficit for FY13 has been estimated to reach 8.8 percent of GDP, which is considerably higher than earlier projections. The source of deviation is structural and well known – low tax revenues due to absence of meaningful tax reforms and continuation of untargeted subsidies without comprehensively addressing the energy sector problems. For FY14, the federal government has announced a provisional estimate of 6.3 percent of GDP. “

“From the monetary policy perspective, it is the financing pressure of the fiscal position that is the source of stress. Due to almost zero net external financing in FY13, the burden of financing the sizeable deficit of 8.8 percent has fallen disproportionately on domestic sources, in particular the banking system. During 1st July – 7th June, FY13, fiscal borrowings from the banking system for budgetary support were Rs1230 billion, including Rs413 billion from the SBP. The high level of these borrowings has kept an upward pressure on the system’s liquidity and thus short term market interest rates and is restraining growth in the private sector credit.”

“If the economy is to reap the benefits of evolving positive sentiments and lure the domestic as well as foreign investors then implementation of a reform oriented and credible medium term fiscal outlook is essential. On its part, the Central Board of Directors of SBP has decided to place a higher weight to declining inflation and low private sector credit relative to risks to the balance of payments position. Therefore, the policy rate is being reduced by 50 basis points, to 9 percent, with effect from 24th June 2013.”

CENTRAL BANK LEAVES POLICY RATE UNCHANGED AT 12 PERCENT;INCREASES MINIMUM PROFIT RATE ON SAVING DEPOSITS FROM 5 TO 6 PERCENT

The Central Board of Directors of the State Bank of Pakistan at its meeting held under the Chairmanship of SBP Governor, Mr. Yaseen Anwar in Karachi today has decided to keep the policy rate unchanged at 12 percent. The State Bank has also decided to raise the minimum Profit Rate on PKR Saving/PLS Saving Products from 5.0 to 6.0 percent.

‘It was the expectation of SBP that these deposits will respond to market forces and adjust accordingly. The rigidity of the deposit rates, especially for small savers, is adversely impacting the savings-investment ratio of the economy, the State Bank of Pakistan said in its Monetary Policy Decision.

It said that a more balanced risk-reward incentive structure is warranted in the shape of appropriate deposit rate structure, as the savers, especially the smaller ones, need to be adequately compensated. ‘Therefore, it has been decided that, effective May 1st, 2012, all Banks are required to pay a minimum Profit Rate of 6.0 percent on PKR Saving/PLS Saving Products,’ it added.

Following is the complete text of the Monetary Policy Decision:

‘As the economy begins the last quarter of current fiscal year, SBP’s monetary management continues to play its part in balancing the implications of multiple challenges faced by the economy. The primary consideration remains bringing inflation further down as it has persistently remained in double digits in the last few years. Ensuring smooth functioning of the payment system and financial stability is also important given the current stressed liquidity conditions in the market. Similarly, elevated international oil prices, weak quantum of exports, and insufficient foreign financial flows require careful management of the external position. Last but not least, the consistent decline in private investment is also an important factor in formulating the monetary policy strategy as it impacts both the medium term inflation, growth and employment prospects.

Given limited set of instruments, not all these challenges can be effectively tackled by monetary policy alone. There are bound to be tradeoffs involved among these competing considerations. A supporting fiscal strategy and an active economic reform agenda is critical to deal with some of the structural  issues,  in  particular,  low  tax  to  GDP  ratio  and  energy  shortages.  Most  importantly,  the economy needs a forward-looking approach to policy making with strict adherence to rules laid out in the legal frameworks, be it the State Bank of Pakistan (Amendment) Act (2012) or Fiscal Responsibility and Debt Limitation (FRDL) Act (2005).

Following this approach is crucial in anchoring inflation expectations around the medium term targets of 9.5 percent for FY13 and 8 percent for FY14 as envisaged in the Medium Term Budgetary Framework (MTBF) of the government. In March 2012 the year-on-year CPI inflation was 10.8 percent and, given the current economic conditions, is projected to remain in double digits during FY13. Consistently growing government borrowing requirement from the banking system is a key variable that is adversely affecting the inflation outlook. Weak private demand, on the other hand, is one reason why inflation is not increasing sharply. Nonetheless, the size of fiscal borrowings and lack of investment is eroding the medium term productive capacity of the economy, contributing towards persistence of inflation in early double digits. Another risk factor that needs to be monitored closely for assessing inflationary pressures is the behaviour of international oil prices.

The current year government borrowings for budgetary support have been Rs373 billion from the scheduled banks and Rs218 billion from the SBP during 1 July – 30 March, FY12. The year-on-year growth in these borrowings turns out to be 56.5 percent and 18.5 percent respectively. The year-on- year growth in the private sector credit, on the other hand, was only 4.2 percent and that in total deposits of the banking system was 17.4 percent during the same period. Thus, despite a decent growth in deposits, the banks continue to prefer financing the fiscal deficit as opposed to searching avenues, taking risk, and building partnerships to facilitate credit to the private sector. The cost to the economy is visible in terms of a decline in investment to GDP ratio to historically low levels and stagnant economic growth that is considerably lower than the economy’s potential.

If a revival in private sector credit and growth prospects is to take place, a pertinent question in the current circumstances is: how would the government rollover its maturing short-term debt and raise additional  financing  while  simultaneously  retiring  its  borrowings  from  the  SBP?  With  shortfalls  in external sources, the most likely avenue will be more borrowings from the SBP. The inflationary implications of this scenario should not be underestimated. However, according to the recent State Bank of Pakistan (Amendment) Act (2012), government borrowing from the SBP is required to be repaid at the end of each quarter and the existing stock is to be retired within eight years. In case of not observing these provisions, the Act also stipulates that the federal government will submit a statement to the Parliament giving detailed justification.

Adherence to this legal requirement, without serious adjustment in the fiscal position, would lead to significant injections of liquidity by the SBP to keep the payment system functioning and financial markets stable. But, SBP is already injecting substantial short term liquidity in the system, Rs200 billion as of 13 April 2012, which is being continuously rolled over. The permanent nature of these injections also potentially carries inflationary risks. Thus, simultaneously meeting the legal requirement of zero quarterly borrowings from SBP, scaling back liquidity injections, effectively anchoring inflation expectations, and creating space for the private sector, could prove to be a much more difficult task than appreciated.

Government borrowing requirements are not the only source of liquidity pressures. With a gradually rising external current account deficit and consistently declining foreign inflows, the SBP’s foreign exchange reserves are on a declining path. During the first eight months of FY12, the external current account deficit was $3 billion while the net capital and financial account receipts were only $187 million. Not surprisingly, SBP’s liquid foreign exchange reserves have declined to $11.8 billion by end- March 2012 from $14.8 billion at end-June 2011. These external sector developments are exerting downward pressure on rupee liquidity as indicated by a 21.4 percent year-on year decline in Net Foreign Assets  (NFA)  of  the  banking  system  by  end-March 2012.  Thus,  some  rupee  liquidity  injection  and increase in reserve money is required to facilitate normal transactions taking place in the economy.

Further, SBP’s operational monetary management framework sets the short term interest rate or the price of liquidity based on broad macroeconomic considerations such as likely inflation path relative to the announced target. The requirement of liquidity and thus growth in reserve money is residually determined and provided to ensure smooth functioning of financial markets. The SBP cannot simultaneously  set  both  the  interest  rates  and  money  growth.  The  challenge  is  if  the  underlying behaviour of a significant user of money does not respond to interest rate signals, then monetary policy would become ineffective in achieving its objectives.

Given substantial external debt payments, declining trend of export quantum, elevated international  oil  prices,  and weak  financial  inflows,  the  external  position is likely  to  remain under pressure in the remaining part of FY12 and FY13.  Similarly, provisional financing data indicate that the fiscal deficit may have reached 4.3 percent of GDP during the first nine months of FY12. Given the last quarter seasonality, a substantial slippage compared to the revised target of 4.7 of GDP cannot be ruled out. Both these developments would have implications for variables that concern monetary policy such as inflation expectations, liquidity pressures, and private investment. In terms of solutions, the economy needs deep and decisive fiscal and energy sector reforms and an early realization of planned foreign financial inflows to mitigate uncertainty.

Another  area  of  reform  is  to  improve  financial  deepening  and  competition in  the  banking system. In this vein, SBP has already been encouraging depositors to put their savings in government securities through Investor’s Portfolio Securities (IPS) accounts. Among other objectives, this is expected to lead to better returns on deposits over time. Moreover, in May 2008, SBP introduced a minimum 5 percent floor on all categories of Savings/PLS Saving Products. Consequently, average deposit rate of all saving  related  products  increased  from  2.1  percent  to  5.25  percent,  with  no  significant  change thereafter. The saving deposits category now account for 38 percent of all bank deposits and 52 percent of total number of deposit accounts.

It was the expectation of SBP that these deposits will respond to market forces and adjust accordingly. The rigidity of the deposit rates, especially for small savers, is adversely impacting the savings-investment ratio of the economy. A more balanced risk-reward incentive structure is warranted in the shape of appropriate deposit rate structure, as the savers, especially the smaller ones, need to be adequately compensated. Therefore, it has been decided that, effective May 1st, 2012, all Banks are required to pay a minimum Profit Rate of 6.0 percent on PKR Saving/PLS Saving Products. At the same time, given the overall macroeconomic conditions, the Central Board of Directors has decided to keep the policy rate unchanged at 12 percent.’