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May 21, 2019

Monetary policy: SBP hikes key interest rate by 150bps to 12.25pc

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May 21, 2019

KARACHI: The State Bank of Pakistan (SBP) announced its monetary policy on Monday, increasing key interest rate by 150 basis points to 12.25 per cent to tackle increasing inflationary pressures.

According to estimates of the central bank, economic growth is expected to be slow in FY (Fiscal Year)19 but rise modestly in FY20. This slowdown is mostly due to lower growth in agriculture and industry.

Average headline consumer price index (CPI) inflation reached 7.0 per cent in Jul-Apr FY19 compared to 3.8 per cent in the same period last year.

Trends in government borrowing reflected a widening fiscal deficit during the first nine months of FY19 when compared to the same period of FY18. In addition, a greater reliance on central bank for financing of deficit acted to dilute the impact of previous monetary tightening.

Finally, the exchange rate depreciated by 5.93 per cent to Rs 149.65 per US dollar, at the close of May 20, 2019, reflecting a combination of underlying macroeconomic factors and market sentiment considerations.

More than two-thirds of real GDP growth in FY19 is expected to come from services.

Going forward, some gradual recovery in economic activity is expected on the back of improved market sentiment in the context of the International Monetary Fund (IMF) supported program, a rebound in the agriculture sector and government incentives for export-oriented industries.

The current account deficit narrowed to US$ 9.6 billion in Jul-Mar FY19 as compared to a deficit of US$ 13.6 billion during the same period last year, a fall of 29 per cent. The reduction is mainly driven by import compression and a healthy growth in workers’ remittances.

This impact was partially offset by higher international oil prices. The non-oil trade deficit declined from US$ 13.7 billion in Jul-Mar FY18 to US$ 11.0 billion in Jul-Mar FY19 reflecting the impact of stabilisation policies implemented so far. Recent indicators suggest export volumes have begun to grow although total export receipts have not grown due to unfavorable prices.

Despite the improvement in the current account and a noticeable increase in official bilateral inflows, the financing of the current account deficit remained challenging.

Consequently, reserves declined to US$ 8.8 billion as of May 10, 2019 from US$ 10.5 billion at end-March 2019.

The exchange rate also came under pressure in the last few days. In SBP’s view, the recent movement in the exchange rate reflects the continuing resolution of accumulated imbalances of the past and some role of supply and demand factors.

The SBP will continue to closely monitor the situation and stands ready to take measures, as needed, to address any unwarranted volatility in the foreign exchange market. Furthermore, the current level of reserves is below standard adequacy levels (equal to three months of imports cover).

As noted in previous MPC statements, deep structural reforms are required to improve productivity and competitiveness of export-oriented sectors and improve the trade balance.

The overall fiscal deficit is likely to be considerably higher during Jul-Mar FY19 as compared to the same period last year due to a shortfall in revenue collection, higher than budgeted interest payments and security-related expenditures.

From a monetary policy perspective, a growing portion of the fiscal deficit has been financed through borrowings from the SBP.

In absolute terms, the government borrowed Rs 4.8 trillion from the SBP during Jul 01 to May 10, FY19, which is 2.4 times the borrowing during the same period last year.

A major portion of this borrowing from the SBP (Rs 3.7 trillion) reflects a shift away from commercial banks which were reluctant to lend to the government at prevailing rates. The resulting increase in monetisation of the deficit has added to inflationary pressures. Despite the recent tightening of monetary policy, private sector credit rose 9.4 per cent during Jul 1 to May 10, FY19. Much of the increase in credit was for working capital needs due to higher input prices.

The expansionary impact of higher government borrowing and private sector credit on broad money supply (M2) was partly offset by a contraction in net foreign assets of the banking sector. In aggregate, broad money supply grew by 4.7 per cent during Jul 01 to May 10, FY19.

The consumer price index (CPI) rose 9.4 per cent in March 2019 and 8.8 per cent in April 2019, on a year-on-year basis. Average headline CPI inflation reached 7.0 per cent in Jul-Apr FY19 compared to 3.8 per cent in the same period last year.

Moreover, the annualised headline month-on-month inflation has risen considerably in the last three months due to the recent hike in domestic fuel prices and rising food prices and input costs. As such, inflationary pressures are likely to continue for some time.

The most recent IBA-SBP consumer confidence survey also shows that most households expect higher inflation during the next six months. Taking into account the recent developments discussed above and outlook for key sectors, average headline CPI inflation is expected to be in the range of 6.5-7.5 per cent in FY19 and it is anticipated to be considerably higher in FY20.

This inflation outlook is subject to a number of upside risks from an expected rationalisation of taxes in the upcoming budget, potential adjustments in electricity and gas tariffs, and volatility in international oil prices. The inflation outlook suggests a fall in real interest rates on a forward-looking basis.

Taking into account the above considerations and the evolving macroeconomic situation, the MPC noted that further policy measures are required to address underlying inflationary pressures from higher recent month-on-month headline and core inflation outturns; recent exchange rate depreciation; (iii) an elevated fiscal deficit and its increased monetisation, and potential adjustments in utility tariffs.

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