CLASS MBA (FINAL)

SEMESTER 3RD

SUBMITTED TO SIR SALMAN B. MEMON

SUBMITTED BY NAVEED A QURESHI 31

MIR ASAD A TALPUR 24
MAZAHAR A RIND 22
NIZAKAT A UJAN
MOHSAN A MEMON
 The Analysis of Monitory Policy of SBP 2006-07

OVERVIEW OF THE ECONOMY

Pakistan’s economy has delivered yet another year of solid economic

growth in 2005-06 in the midst of an extraordinary surge in oil prices and
the devastating earthquake of October 8, 2005. With economic growth at 6.6
percent in 2005-06, Pakistan’s economy has grown at an average rate of
almost 7.0 percent per annum during the last four years (2002/03 – 2005/06)
and over 7.5 percent in the last three years (2003/04 – 2005/06), thus
positioning itself as one of the fastest growing economies of the Asian
region.

HIGHLIGHTS

Monetary policy measures adopted in July 2006 augmented earlier

tightening and reduced YoY core inflation (Non-Food Non-Energy – NFNE)
to 5.5 percent by December 2006 from 7.4 percent a year earlier. However,
the headline inflation remained stubbornly high at 8.9 percent by December
2006. Although non-food inflation declined to 6.2 percent, acceleration in
food inflation to double-digit levels offset the downtrend in headline
inflation.
In line with its dual objective of balancing growth and price stability,
monetary policy has also supported economic growth by ensuring effective
liquidity management as well as providing adequate and timely concessional
credit to priority sectors. Specifically, the liberal access of concessional
Long-term Financing for Export Oriented Projects (LTF-EOP) offered by
SBP and reduced rates on Export Finance Scheme (EFS) were helpful in
keeping the textile industry’s growth prospects intact.
Concessional financing by SBP, nevertheless, has contributed
significantly to growth of reserve money during H1-FY07. The reserve
money increased by 19.0 percent during H1-FY07 compared to the 8.4
percent growth recorded in the corresponding period last year; credit under
EFS and LTF-EOP together explained around 54 percent of the absolute
change in reserve money in H1-FY07 over H1-FY06. As a result, risks of
emerging day-to-day excess liquidity seem to have increased in the money
market.
Another source of reserve money expansion has been the build up in
Net Foreign Assets (NFA) during H1-FY07 in contrast with a depletion
during H1-FY06. Hence, a policy action to help smooth out liquidity
management by scheduled banks is in order.
While keeping the average weekly cash reserve requirement same as
before (3 percent for time and 7 percent for demand liabilities), SBP is
increasing daily minimum requirements to 2 percent and 6 percent for time
and demand liabilities (from earlier levels of 1 percent and 4 percent)
respectively.
Key challenges facing the Pakistan economy remain the same as were
at the beginning of FY07. In particular,
(a) while inflation is likely to ease-off further it may remain above the
6.5 percent target for FY07 unless some additional administrative measures
are taken to reduce food inflation;
(b) International commodity prices may exert pressure on domestic
inflation;
(c) Reserve money growth is increasing, among others because of
textile sector support which is backed by SBP refinancing;
(d) expansionary fiscal stance coupled with occasional upsurges in
borrowings from SBP and the uncertainty created by financing mix of
the deficit is posing difficulties for the conduct of monetary policy;
and
(e) Burgeoning external imbalances also continue to pose a challenge.
SBP will continue to pursue its existing tight monetary policy stance
during the remaining half of FY07. It will, however, remain vigilant of the
developments in the economy and take corrective actions, if warranted.

POLICY ASSESSMENT

Macroeconomic Environment and SBP Response in H1-Fy07

While the earlier monetary tightening did help in bringing down
inflationary pressures in FY06, a further moderation in aggregate demand
during FY07 was required as: inflation at 7.9 percent in FY06, though
remained within target for the year, was still high; core inflation witnessed a
relatively smaller decline in FY06, reflecting that demand-side inflationary
pressures remained strong;
• The FY07 inflation target of 6.5 percent required a decline of
1.4 percentage points over FY06, which would have been
highly ambitious without further monetary tightening; and
• External account pressures were expected to increase further in
FY07, as current account deficit was envisaged to widen from
the already high level of FY06.
However, the responsibility of moderating the aggregate demand fell
on monetary policy given that the exchange rate is market determined; and
• The federal budget for FY07 clearly signaled an expansionary
fiscal policy stance.
On the one hand, policy measures were required to curb existing
inflationary pressures; and on the other, it was equally essential to ensure the
availability of credit for exporters and long-term industrial investment to
keep growth prospects intact.
The task of achieving a balance between inflation and growth was
difficult also because by the end of FY06, some of the key industries were
working at near- full capacity. The resulting capacity constraints, in the
presence of strong aggregate demand, had been contributing towards high
inflation in the country, besides limiting economic growth prospects beyond
its realizable potential.
Thus, prudence required that monetary tightening should not
adversely impact the continuing investment demand in the economy and the
long-run growth momentum. In this backdrop, SBP not only focused on
further monetary tightening but also allowed the export sector liberal access
to concessional credit.

‘The macroeconomic environment at the beginning of FY07

warranted aggregate demand moderation’.

‘Real GDP growth target of 7 percent, with high inflation and

expansionary fiscal policy made monetary policy management very
challenging’.

Monetary Policy: An important lesson that we learnt from the experience of

the decade of the 1990s is the importance of a healthy banking and financial
sector. This is a key element of macroeconomic stability. A weak financial
sector can undermine efforts to achieve stability through prudent fiscal and
monetary policies. A strong and well-functioning financial and banking
sector is also critical for sustained higher economic growth. They can
provide credit to those investments that offer the highest risk adjusted rates
of return. In recent years the banking industry in Pakistan has been
transformed from state owned sector to a vibrant private sector industry.
Banking industry has not only gained strength from the positive interplay of
economic and political factors, but also has become an engine of growth for
the economy. The easy and accommodative monetary policy stance that had
been pursued during the last few years by the SBP underwent considerable
changes during the fiscal year 2004-05, switching from a broadly
‘accommodative' to ‘aggressive tightening’ in the second half of the last
fiscal year, more so since April 2005 to tame inflation. Overall inflation in
general and core inflation in particular, continued to exhibit a rising trend
during the fiscal year 2004-05; the overall inflation reaching as high as 11.1
percent and core inflation at 7.8 percent in April 2005. In order to arrest the
rising trend in inflation, the SBP changed its monetary policy stance to
aggressive tightening in April 2005 by raising discount rate from 7.5 percent
to 9.0 percent. The same tight monetary policy stance continued during the
current fiscal year despite declines in both core and overall inflation.
Notwithstanding the tight monetary policy stance the SBP continued to
strike a balance between promoting growth and controlling inflation on the
one hand and maintaining a stable exchange rate environment on the other.
Tight monetary policy stance is likely to continue until inflationary pressures
are significantly eased off.

MONETARY POLICY: Rising Inflation and Difficult Choices

The SBP appears to be saying it has done as much as it can to control

inflation and it is now up to the government to take corrective measures on
the administrative or supply-side to bring down food price inflation that has
led to Pakistan's overall inflation rate to accelerate to a twelve-month high of
8.9 per cent in December. The Governor left the benchmark policy rate (3-
day Repo Rate) unchanged at 9.5 per cent.

The monetary policy statement of the State Bank of Pakistan (SBP) makes
two other important points: (a) inflation remains stubbornly high and is
likely to exceed the 6.5 per cent target for the current fiscal year, and (b) the
monetary policy continues to be supportive of the economic growth as
threshold level of inflation for a stable economic growth. in the range of 4-6
percent.
The assertion that Pakistan, being a developing country, needs a high
inflation rate (6 per cent or so) to support a 6-8 per cent GDP growth is
seriously questionable and is not supported by hard evidence from the most
recent comparable GDP growth and inflation data of some major emerging
markets as shown in graph 1.

Pakistan stands out with the highest inflation rate and the only country in the
group whose inflation rate (8.9 per cent) is more than its GDP growth rate
(6.6 per cent). This suggests that either there is something so unique about
the structure of Pakistan’s economy that the divergence of its GDP growth
and inflation data from the norm of even other developing and oil importing
countries (leave aside those of the developed markets) has a valid and
legitimate reason or the data itself is questionable.

However, even if we take data at its face value, the graph shows that most of
these developing countries are growing at around six per cent or more while
their inflation rate is around four per cent or thereabouts. The only exception
is India whose inflation rate is 6.7 per cent but then its current GDP growth
rate of 9.2 per cent is also significantly higher than Pakistan’s 6.6 per cent.
The monetary policy statement does acknowledge that the inflation is
relatively higher compared to its competitors and trading partners and this
higher domestic inflation has offset the gains emanating from nominal
depreciation of the rupee against other currencies. Is it making a case for an
accelerated depreciation of rupee in the coming months because the
monetary policy has failed to achieve the inflation target?

When most of major developing countries are recording healthy GDP

growth while keeping overall inflation (this includes food and energy
inflation) under five per cent, should not the government set five per cent

inflation rate as target for the next fiscal year? This assumes additional
significance - aside from domestic economy and political considerations in
an election year - since the relatively higher inflation is hurting
competitiveness and exports growth instead of supporting the declared
policy objective of encouraging economic growth.

Still, it is fair to say that the SBP, primarily through open market operations
and changes in the reserve ratios, has managed to bring down the overall
growth rate in the private sector borrowings. Based on the monthly average
loans outstanding of the scheduled banks, the loan growth during the six
months to December 2006 was 14.5 per cent compared to 25.3 per cent
growth during the previous year.

However, the impact of the overall tightening in the credit supply has been
somewhat diluted by a Rs34.7 billion increase in loans under Long-term
Financing for Export Oriented Projects (LTF-EOP) and R26.8 billion
increase in loans under Export Finance Scheme (EFS), both offered at
concessional or reduced rates.
The combined increase in loans under these financing schemes accounted
for 54 per cent of the Reserve Money (M0) growth during the first half of
the current fiscal year. Although there may be legitimate reasons for offering
export financing at concessional rates, the reports about the abuse of such
facilities abound with money being diverted to real estate and stock market
investments. Such schemes can offset the benefits of a monetary tightening
and derail the progress made in since late 2004. Given their large proportion
in overall money supply growth, it is fair to argue that their rapid build-up
may have adverse effects on the core function of the monetary policy, that is,
achieving low inflation in the next 12-18 months.

Notwithstanding this, the impact of the monetary tightening is visible in

rising interest rates and a deceleration in the principal indicator of the money
supply that is M2, during the first six months of FY2006-07. The three-
month Karachi Interbank offered rate (KIBOR) averaged 10.39 per cent
during December 2006 compared to 8.98 per cent during January 2006.
While raising interest rates is a perfectly legitimate response to building
inflationary expectations, there is an other side to it.

If real interest rates, that is, nominal interest rates minus inflation, are higher
compared to a country’s competitors, they can hurt growth, particularly
exports. Some policy makers argue that the local businesses and
industrialists should not just look at the lower nominal interest rates in India
because Pakistan’s inflation rate is higher. Simple enough, but a comparison
of the real interest rates between Pakistan and India reveals a somewhat
different and more complex picture.

Graph 2 shows real interest rates in Pakistan and India. The monthly
averages of 3-month KIBOR and 3-month MIBOR (Mumbai interbank
offered rate) and monthly inflation (CPI) rates were used to calculate the real
rates. The graph shows the real interest rates in Pakistan have stayed
generally higher during 2006 compared to India’s. Although it is difficult to
quantify the impact, higher real interest rates do contribute to higher cost of
production and hurt international competitiveness.

Moreover, the data has some difficult implications from a monetary policy
standpoint. The real interest rates in Pakistan depict a declining trend since
mid-2006 while those in India show an upward trend.

Declining real interest rates can portend a higher inflationary environment

18 months down the road, as monetary tightening takes at least that long to
make a dent in inflation. Here, it is relevant to note that the SBP’s last
Thursday statement starts with a rather bold assertion that “monetary policy
measures adopted in July 2006 augmented earlier tightening and reduced
core inflation (Non-Food Non-Energy – NFNE) to 5.5 per cent by December
2006 from 7.4 per cent a year earlier.”

Given the widely accepted view, acknowledged even by the SBP Governor,
that monetary policy takes 18 months or so to impact inflation rate; it is not
clear how the July tightening has caused headline inflation to drop in just 6
months? While this may be excused as a statement made more for public
consumption rather than on a serious note, more important issue is the recent
and growing trend of emphasising core inflation as opposed to overall
inflation that includes food inflation. Maybe it is just a better number to talk
about because it looks good.

On the other hand, one may argue that core inflation is also followed closely
in the developed economies such as the United States. However, there is a
major difference between Pakistan’s inflation (CPI) measure and those of
the developed world. Food inflation is the single largest component of
Pakistan’s CPI and constitutes 40 per cent of this index compared to only 17
per cent or so in the U.S. and some other developed markets.

Together with energy, food inflation accounts for almost 48 per cent of the
CPI or overall inflation in Pakistan. Therefore, in Pakistan’s context, core
inflation (that is, Non-Food Non Energy inflation) is not as meaningful a
measure as in some other developed countries. While supply-side factors do
play a role in inflation, this should not detract the central bankers from
targeting the overall inflation rate as the primary focus of the monetary
policy. Monetary tools, such as margin requirements, do play a role in
commodity financing and should be used appropriately to respond to the
financing needs of essential items.

Moreover, while financial deregulation and innovation have made the

money supply harder to interpret in the developed markets, domestic money
supply control can be a relatively more effective tool of monetary policy in
economies like Pakistan where private sector access to foreign borrowing
and markets is fairly limited. The fact that a large sector of the economy is
undocumented has little to do with the effect of money supply growth on
inflation as has been well established in high inflation developing countries
like Brazil and Turkey.

The SBP maintains it is capable of skilful management of the often difficult

and complex objectives of meeting national growth priorities, liquidity and
demand management, and controlling inflation. As central bankers around
the world know too well from history, it is difficult to manage just one goal
– low inflation – let alone many.

Given the propensity of the borrowers in Pakistan to abuse concessional

credits and the difficulties in managing multiple and some times conflicting
near-term policy objectives, the SBP will be better off to make achieving an
inflation rate of five per cent or less as its core target for next 12-18 months.
That by itself will facilitate growth and price stability. Failure to achieve low
inflation will hurt growth and exports down the road as monetary policy
mistakes can take up to 18-24 months to show up in even higher inflation
numbers. But by then, elections will be over.

Per Capita Income: Per capita income is one of the main indicators of
development. It simply indicates the average level of prosperity in the
country or average standard of living of the people in a country. Per capita
income defined as Gross National Product at market price in dollar term
divided by the country’s population, grew by an average rate of 13.9 percent
per annum during the last four years – rising from $582 in 2002-03 to $847
in 2005-06. Per capita income in dollar term registered an increase of 14.2
percent over last year – rising from $ 742 to $ 847.

Investment: Investment is a key determinant of growth. During the fiscal

year 2005-06, gross fixed capital formation or domestic fixed investment in
real term grew by 10.3 percent as against 9.3 percent last year. The real
private sector investment grew by 11.0 percent this year as against an
increase of 9.6 percent last year. Public sector investment on the other hand
registered a substantial increase of 22.5 percent as against a robust growth of
10.0 percent last year.

According to the credit plan for 2005-06, the SBP has set the target for
monetary expansion to the tune of Rs.380 billion or 12.8 percent higher than
last year (FY05) on the basis of a growth target of 7.0 percent and inflation
target of 8 percent. The growth target of broad money (M2 definition) was
deliberately kept below the growth of nominal GDP to absorb monetary
overhang of the last few years.

Exports: Exports were targeted at $ 17 billion or 18.1 percent higher than

last year. Exports during the first nine months (July-March) of the current
fiscal year are up by 18.6 percent – rising from $ 10.18 billion to $ 12.07
billion in the same period last year.

Imports: Pakistan’s imports continue to be pushed higher by unprecedented

rise in oil prices and continued strength of non-oil imports owing to buoyant
domestic demand. Imports were targeted to grow by 4.25 percent for the
fiscal year 2005-06 – rising from $ 14.4 billion to $ 20.7 billion. Imports are
up by 43.2 percent in the first nine months (July- March) of the current fiscal
year – rising from $ 14.45 billion to $ 20.69 billion in the same period last
year.

External Debt: Until a few years ago, Pakistan was facing serious
difficulties in meeting its external debt obligations. Not only was the stock
of external debt and foreign exchange liabilities growing at an average rate
of 7.4 percent per annum during 1990-99, but the debt carrying capacity of
the country was weakening at a similar pace. Consequently, the debt burden
(external debt and foreign exchange liabilities as percentage of foreign
exchange earnings) reached an unsustainable level of 335 percent by 1998-
99. Following a credible strategy of debt reduction, over the last six years,
Pakistan has succeeded in not only slowing the pace of debt accumulation
but also succeeded in reducing the country’s debt burden in a substantial
manner. Pakistan’s external debt and liabilities have declined by $ 2.4
billion in seven years — down from $ 38.9 billion at the end of the 1990s to
$36.5 billion by end-March, 2006.