Unveiling the monetary policy statement at a press conference held at the SBP premises, SBP Governor Yaseen Anwar said excessive borrowing by the government was a violation of rules and inflation would increase.

He said the cut in benchmark interest rate would come into force on August 13, 2012. This is the first discount rate cut since late last year. While analysts had been predicting a reduction in interest rates, the size of the cut took most by surprise.

According to the SBP governor, the cut was necessitated by the fact that total investment, as a percentage of GDP, fell to 12.5 percent in FY12, which does not bode well for the future productive capacity of the economy.

Justifying the cut, the governor said improved inflation figures and a decline in loans to the private sector had led to an increase in real interest rates. “Year-on-year inflation has declined to 9.6 percent in July 2012 from 12.3 percent in May 2012 on the back of the unanticipated fall in international oil prices in May and June, and a huge reduction of 50 percent in the administered prices of gas in early July 2012,” said Anwar.

Admitting that the oil prices were on the upward march again, the governor maintained that the decline in inflation had created strong market expectations for a downward revision in the SBP’s policy rate. “There has been a noticeable reduction in yields on the government securities in the secondary market and Kibor,” he said.

According to the SBP figures, the net flow of credit to private sector businesses was a meagre Rs18.3 billion in FY12, which was a drastic decline compared to a net flow of Rs173.2 billion in FY11. Not only was the amount disbursed was smaller, retirements from them were also unusually high.

Anwar said the main factors that significantly dampened the demand for credit by private sector businesses were persistent electricity and gas shortages, challenging political environment. These circumstances, he said, pushed businesses to avoid significant commitments in terms of expansion and long term investments.

Further, added Anwar, scheduled banks continue to prefer government over the private sector. According to the monetary policy statement, the fiscal borrowings from the scheduled banks grew by 50 percent in FY12 and contributed 67 percent to the overall increase of 14.1 percent in M2.

Apart from crowding out the private sector, these substantial and, at times, unpredictable fiscal borrowings created substantial challenges for monetary management. However, even so, the governor found reason to be optimistic. “Given a retirement of Rs198 billion during the first month of FY13, it seems that the fiscal authority is beginning to make efforts to reduce its borrowings from the SBP,” said Anwar.

However, Anwar admitted that an improvement in key economic indicators would require comprehensive and credible reforms in the energy and fiscal sectors.

The governor also sounded an unusually optimistic note about the impact of the cut on the balance of payments. “I have no concerns over the balance of payments position for FY13 as capital and financial accounts of the country are expected to improve this year,” said Anwar. “The additional inflows under Coalition Support Fund (CSF) will come to the country by end-December 2012. FDI inflows will further witness some pickup during this fiscal year.”

Further, he said that Pakistan has made two currency swap agreements with Turkey and China, which will come into effect by the year-end, which will further ease the pressure on foreign exchange reserves.

The real focus during FY13, said Anwar, would need to be on the prospects of improving financial inflows so that the economy can build foreign exchange reserves to meet rising debt obligations in the next few years.

The governor said the SBP projects average CPI inflation for FY13 to remain in the range of 10 to 11 percent, which is higher than the announced target of 9.5 percent for FY13. “However, much would depend on fiscal restraint on borrowings from SBP, realisation of estimated foreign financial inflows, and improvement in energy shortages to increase the utilisation of installed capacity,” he added. The SBP is also projecting growth in real GDP for FY13 to remain between three and four percent; well below the target for the year.