Risks from twin deficits heighten : SBP raises interest rate by 100bps to 7.5 percent

KARACHI: The central bank on Saturday raised its interest rate by a sharp 100 basis points to 7.5 percent, the biggest push in 10 years, and flagged concerns about

economic uncertainties, which remain the key factor for policy tightening this year.

“… to curb aggregate demand and ensure near-term stability, the (monetary policy) committee has decided to increase the policy rate by 100 bps (basis points) to 7.50 percent effective from 16 July,” Governor Tariq Bajwa of the State Bank of Pakistan (SBP) told a news conference.

“We are following a contractionary monetary policy to prevent overheating,” Bajwa said.

The SBP enumerated four reasons behind this year’s third hike.

“The multiplier effect of a strong fiscal expansion during the second half of FY18 is likely to offset the contractionary impact of monetary tightening in the recent months on domestic demand,” it said in a monetary policy statement. “Higher international oil prices have continued to inflate the import bill.”

The SBP said rising inflation projections and the ensuing fall in real interest rates and a notable reduction in rupee and US interest rate differential are contributing to evolving economic challenges.

“This means that aggregate demand has proved to be higher than previously thought,” the SBP said. “Core inflation numbers and their one-year ahead projections at around 7 percent also reflect demand pressures.”

June inflation clocked in at 5.2 percent, and the average headline inflation for FY19 is expected to cross the six percent annual target.

“Based on these recent estimates, SBP’s model-based range for average CPI inflation is 6.0–7.0 percent for FY19,” it said.

The SBP said the challenges to Pakistan’s economy have further accentuated. It projected GDP growth to be around 5.5 percent for the current fiscal year of 2018/19 as compared to the annual target of 6.2 percent.

The SBP further said the current account deficit increased to $16 billion during Jul-May FY18, which is 1.4 times over the same period last year. The SBP said a favourable impact of a strong recovery in exports and increase in workers’ remittances in the July-May period was more than offset by growing imports.

“…strong demand for productive imports (metal, transport, machinery and petroleum) to support higher economic activity and a sharp increase in international oil prices have pushed the current account deficit to levels not sustainable beyond the short term,” the central bank said in the statement.

“In the absence of matching financial flows, a notable portion of this higher current account deficit was financed by using the country’s own resources.”

The SBP said its liquid foreign exchange reserves witnessed a net reduction of $6.7 billion to reach $9.5 billion as of July 6. “These developments suggest that the near-term management of the country’s external accounts is of critical importance.”

On a question, SBP governor said the next government has to decide about any bailout package from the International Monetary Fund.

“Let the new government come and we’ll make the recommendations on how the policies relating to interest rates and exchange rate would be implemented,” he added.

“We think the management of the foreign exchange reserves by the central bank should be based on one-year, rather than six months as recommended by the caretaker finance minister.”

He said the international benchmark of foreign currency reserves management is for three months.

Bajwa said exports competitiveness is increasing due to currency depreciation.

“We took exchange rate, administrative, monetary policy measure as well as withdrawal of advance payments against imports to curb higher imports growth, but spike in global oil prices offset these impacts.”

He said the central bank may take more administrative measures, such as imposition of 100 percent cash margin requirements on the imports of non-essential items to combat higher import bill.

Governor said the country is facing near-term challenges, but mid-to-long-term “prospects are bright”.

On money-laundering arrests and their impacts on the banking sector, Bajwa said Summit Bank is meeting all the necessary obligations.

“This case would not affect the bank’s operations,” he added. “The financial health of the bank would remain intact. We have already frozen the sponsored shares of the bank.”

SBP governor said the country’s banking sector is “stable and strong”.

On tax amnesty, he said the central bank is facilitating the government to implement the scheme.

The SBP, in the statement, said its provisional estimate for fiscal deficit is 6.8 percent for the last fiscal year of 2017/18 as opposed to 5.5 percent estimated in May.

The SBP said stock of private sector borrowing increased Rs.768 billion in FY18, which translates into a growth of 14.8 percent, despite some slowdown in fixed investment and particular issues of the sugar and fertiliser sectors.

“In FY19, private sector credit is expected to increase by almost the same amount at a growth rate of about 13 percent,” it said.

“This will be driven primarily by the rise in need for working capital at the back of gestation of lagged fixed investment into production and rising exports.”

The SBP said the expansionary impact of net domestic assets on broad money supply has been partially neutralised by net contraction in foreign assets of the banking sector.