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Monetary Policy Executive Summary Pakistan

Monetary Policy Executive Summary Pakistan

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Published by AAMIR SHEHZAD ARAIN

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Published by: AAMIR SHEHZAD ARAIN on Jul 03, 2009
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Executive Summary
Pakistan’s economy has started to show signs of the beginning to an end of a year long period of mounting difficulties andchallenges, yet it has not solved all of its problems. The ensuingvulnerabilities and risks posed complex policy questions that occupiedthe country during most of 2008. The stress on macroeconomic stabilitywas most visible in an unsustainable balance of payments position andthe falling value of the rupee. Together with this, escalating CPI inflation,driven both by food and non-food components, and structural problemssuch as power shortages leading to a gradual decline in real economicactivity, aggravated the pressure. The enormous size and skewedfinancing mix of the fiscal deficit that tilted heavily towards central bankborrowing, liquidity shortages in the money market, and strains in theoverall banking system added to an already worsening situation. Thedomestic socio-political upheavals and rapidly changing global economicenvironment also contributed to these multifaceted problems. Thesediverse developments entailed complex interactions and led to anincreasingly intricate menu of policy trade-offs. In response, and keepingin view the economic outlook for FY09, the SBP tightened the monetarypolicy further by increasing the policy discount rate by 100 bps in July2008. The final judgment categorically stated that the risks to theinflation outlook were far greater than risks to economic growth andreckoned the necessity of well coordinated stabilization measures. Giventhe emerging liquidity issues, SBP also took a host of measures inOctober 2008 to address problems related to liquidity management bybanks. In continuation of its resolve to support a return tomacroeconomic stability,
Interim Monetary Policy Measures
wereannounced on 12th November 2008. The increase in the policy discountrate from 13 to 15 percent was taken after assessing the developmentsduring the first four months of the current fiscal year and seeing novisible turnaround in the highlighted risks and challenges faced by theSBP. Tight monetary policy, however, was only one ingredient of themacroeconomic stabilization program; several stabilization and structuraladjustments were required immediately and in the medium term to putthe economy back on a stable path.More importantly, the
Interim Measures
outlined the contours of themacroeconomic stabilization program prepared by the SBP and thegovernment. Since the corner stone of the stabilization program was anurgent need to plug the
Monetary Policy Statement, January – March 2009
2
 
‘financing-gap’ of $4.5 billion during FY09, a Stand-by Arrangement(SBA) was signed with the IMF towards the end of November, 2008 (see
Appendix
for details).Although it is too early to evaluate the benefits of all the measures thatthe stabilization program stipulates, yet by January 2009 there are earlysigns of improvement in the outlook for some important economicvariables such as inflation, foreign exchange reserve, import growth, andgovernment borrowings from the SBP. Two broad reasons underlie thesepositive developments.First, some of the important policy measures and adjustments, which area part of the macroeconomic stabilization package, have already beenworking their way through the economy and are likely to contributetowards achieving stability by the end of FY09. These include: (i)frequent and timely adjustments in the policy interest rate that resultedin a cumulative increase of 500 bps during 2008 kept the aggregatedemand and inflation expectations from spiraling out of control; (ii)rationalization/elimination of subsidies, especially on petroleum productsthat had wrecked havoc with the government’s budget of FY08. Out of abudget deficit of Rs777.2 billion in FY08, Rs395 billion were spent onsubsidies; and (iii) an inevitable yet needed and market drivenadjustment in the exchange rate helped in putting a dent in an otherwiseunsustainable growth rate of imports. After a cumulative depreciation of 11.5 percent in FY08 and a further slide of 13.5 percent in FY09 up till30th January 2009, the import growth has slowed down from 31.2percent in FY08 to 15.4 percent in H1-FY09.Second, two phenomena that had hitherto diluted the effects of the tightmonetary policy have changed their direction: (i) there has been anoticeable decline in the volume of government borrowings from the SBPfor budgetary support. This has been made possible because preferencefor subsidy took a back seat, especially after the confidence-invoking anddiscipline-inducing home grown stabilization package that also paved theway for successful conclusion of SBA. For example, during Q1-FY09, thegovernment borrowed Rs264.4 billion from the SBP, while this amountreduced to Rs44.3 billion during Q2-FY09; (ii) After touching a record highof $147.3/bbl on 11th July 2008, oil prices have slumped to around$40/bbl as on 27th January 2009; a fall beyond national and internationalexpectations and projections. This drastic fall in international prices willprovide a much needed respite for the trade account and coupled withtight monetary policy and prudent exchange rate management willstrengthen the balance of payments position. CPI inflation is also likely tobenefit from this development.
Monetary Policy Statement, January - March 2009
3
 
Despite these preliminary positive indications it would be imprudent tolower the guard at this stage. A number of measures suggested in thestabilization package, especially those related with structural issues, stillneed to be implemented to put the economy back on a sustainable pathof growth and development. Even the macroeconomic indicators thathave recovered and the ones likely to post improvement in the next sixmonths justify only restrained optimism on close inspection.Furthermore, the full impact of demand and liquidity managementmeasures taken by the SBP during 2008 have yet to materialize. The excessive drain of rupee liquidity from the system in October 2008,which was precipitated by falling net foreign assets, strong creditdemand, and other seasonal factors, was largely addressed by astaggered lowering of Cash Reserve Requirement (CRR) and exemptionof time liabilities from the Statutory Liquidity Requirement (SLR). As aconsequence, however, overnight repo interest rate fell in the followingweeks and continued to remain at a relatively lower level even after theincrease in the policy discount rate on 12th November 2008 by 200 bps. The low levels of weekly average overnight repo rate of around 10.3percent (for the week ending 23rd January 2009) essentially entailsoftening of the monetary policy stance. This was done consciously bythe SBP to keep money market sufficiently liquid while remaining vigilantin draining excessive liquidity build-ups. Two consideration prompted the SBP to remain cautious in mopping upthe liquidity: (i) there were concerns about some lingering effects of liquidity problems in some segments of the market; (ii) it allowed thebanks to increase their participation in the T-bill auctions and thus helpedin lowering the reliance of the government on borrowings from the SBP.In the six auctions held since the
Interim Monetary Policy Measures
,November 2008, Rs482.1 billion was realized to the government againstthe maturities of Rs321 billion, which helped the government to meet itsend-December targets under the SBA.A prudent approach to liquidity management is necessary in the currentcircumstances to ensure meeting quantitative targets in the SBA. Flooron SBP Net Foreign Assets (NFA) and ceilings on SBP Net Domestic Assets(NDA) and government borrowing from SBP will ensure that softeningmarket interest rates remain consistent with achieving macroeconomicstability. In fact, reducing government borrowing from SBP will also helpentrench expectations of a sustained decline in inflation. Moreover,increased participation of banks in auctions indicates their
Monetary Policy Statement, January – March 2009
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