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| June 13, 2002 | Thursday | Rabi-us-Sani 1, 1423 |
An overview of SBP third quarterly report
KARACHI, June 12: The State Bank of Pakistan on Wednesday released third quarterly report for 2001-2002. Following is the text of overview of the report:
The most noteworthy development during the third quarter of FY2002 was the continued improvement in the country’s external account. This improvement was broad-based—a reduced trade deficit, substantial decline in the services account and a large rise in the current transfers, all contributed to this positive outturn.
Worker remittances, in particular, remained at approximately twice the corresponding levels of the previous year. In fact, the net inflows were sufficient to warrant a further substantial appreciation of the rupee, were it not for the SBP’s conscious decision to purchase heavily in the inter-bank market in order to boost reserves, and to protect exporters.
With just three months remaining to the end of fiscal year 2002, it seems that the timely interventions by the authorities (increased tax refunds, monetary easing, etc.) timely rains, the continuing impact of structural improvements in the external account, and a modicum of luck may have rescued the domestic economy from a very poor showing in FY02. As a result, real GDP growth could comfortably cross the 3 per cent mark, supported equally by a reasonable, under the circumstances, performance by large-scale manufacturing and a small revival in agricultural output (if positive expectations from the wheat crop and the non-crop sector, are realized).
The external account improvement also provided an enabling environment for the SBP’s looser monetary stance in FY02, allowing the central bank to accelerate the downtrend in domestic interest rates in response to the shocks to the economy due to Q2-FY02 events.
This said, it must be pointed out that the situation of the economy is far from satisfactory. Water shortages once again bedevilled the agricultural sector, pulling down a potentially more impressive recovery in the sector. It is no coincidence that the large portion of the agricultural recovery in FY02 is attributable to the kharif crop — it requires 50 per cent more water than the rabi crop and it was the early rains in the kharif that averted a fall in agriculture output.
Despite the perceptible shifts towards diversification, agriculture will likely remain at the heart of the domestic economy for the foreseeable future. Therefore, if the economy is to sustain substantial growth in future, urgent attention is required to improve the infrastructure for the agricultural sector, including, but not limited to, better water storage and supply facilities, enhanced access to credit, increased capacities for storage of food grains, crop insurance, etc.
In view of the improving macroeconomic fundamentals, large scale manufacturing (LSM) growth, too, has been a little disappointing. It appears that despite the supportive policies of the government and the SBP, many sub-sectors could not shrug off the impact of the Q2-FY02 turmoil in the domestic and export markets.
The weakness in the broader economy had obvious negative repercussions for government revenues, with net tax collections falling 5 per cent short of even the thrice-adjusted Rs414.2 billion target for FY021. It must be noted that a part of the lower net collections stemmed from enhanced payments of tax refunds — since a large part of these comprised arrears, this implies that a similar drag on FY03 collections should not repeat itself. Nonetheless, given that (1) even gross collection rose only 3.5 per cent in year-on-year terms during July-March 2002, and that (2) the value in dutiable imports may remain low in coming months2 , it is clear that the restructuring of the CBR, to broaden the tax base and enhance revenue, is imperative. The failure to do so will contribute either to the continuation of high fiscal deficits, eroding the macroeconomic gains directly, or if controlled by lower development expenditure, lead to the general deterioration of the infrastructure necessary for economic growth.
In the external sector, the current account rose another $820 million during Q3-FY02 to take the cumulative surplus to an unprecedented $2095 million. While very welcome, this “improvement” has to be viewed with a degree of caution, and without invoking a sense of complacency or self-congratulation. The challenges ahead are difficult. The lower trade deficit is quite narrowly based on lower imports of sugar and a considerable decline in oil prices, both of which depend on exogenous factors, i.e. one bad sugarcane crop and a sharp jump in international oil prices could easily leave the trade balance in the red again. This vulnerability can also be discerned in other components of the current account. The services account is bolstered by payments of $300 million on account of the basing charges paid by the international forces policing Afghanistan, while higher current transfers benefit from a $600 million non-repeating grant paid by the US government. Adjusted for the one-time gains, as well as the uncertain benefits of the trade account, the FY02 current account improvement falls to approximately $420 million (less than the $783 million FY02 growth in worker’s remittances).
So far, the more impressive and somewhat durable gain appears to be on account of remittances, which have roughly doubled as the kerb market premium plummeted and the informal money transfers drew greater regulatory scrutiny internationally. The above discussion thus only suggests the need for urgent policy changes to consolidate the real improvement in the current account by subsuming the informal foreign currency markets into the formal system. The SBP intends to take the first step to this end by bringing foreign exchange companies into existence in FY03 to capture a larger portion of the potential remittances that currently flow into the informal market3.
The other noteworthy development was the continued rise in the quantum of exports particularly given the adverse trading environment. In fact, it is the decline in unit values of textile exports that has not allowed higher earnings. While the resumption of higher growth in the OECD countries holds a better promise for value0added textile exports in the coming years, the trend also underlines the urgency for moving away from commodity exports.
The imponderables about the current account taken together with the CBR’s poor revenue generation record serves to underline the fragility of monetary sector improvements as well. Firstly, a key element in the SBP’s ability to sharply lower interest rates during FY02 was the high liquidity in the banking sector. As detailed in Section 5, this ultimately derived from the liquidity injections due to the SBP’s foreign currency purchases (from both, the formal and informal markets) and allowed a significant fall in the government’s budgetary borrowings away from the SBP without crowding out private sector demand. The magnitude of these flows for FY03 is obviously still uncertain.
The most unambiguous positive for the economy is the fall in Pakistan’s External Debt and Liabilities (ED&L) by end-FY02 — this is the first visible sign of the country progress in moving out of its debt trap. The ED&L are projected to fall by approximately $2 billion compared to the FY00 figure of $37.9 billion. Although the debt component has actually risen by $768 million due to positive net inflows from international financial institutions, this has been off-set by a much larger ($2.8 billion) fall in foreign currency liabilities. Interestingly, even the rise in the debt is part of SBP strategy to lower the country’s external debt servicing burden, by substituting very expensive debts with soft loans.
The agenda for economic revival remains the same as spelled out in the preceding Quarterly Reports, with fiscal discipline and an aggressive strategy to consolidate the gains on external front remaining the essential elements for the necessary macroeconomic environment. Early reform of the CBR, privatization of key state owned enterprises (public sector banks, KESC, PTCL, etc.) curtailment of losses in the public sector and increased development expenditures, particularly in water storage and conservation, are the priority elements of this agenda.
The forthcoming budget should aim to accelerate the pace of public investment in the coming year to strengthen the foundation for growth and to stimulate the economy. It is quite obvious by now that for a variety of reasons the private sector remains shy as far as new investment is concerned. Given the fiscal space freed by debt re-profiling and reduction in the government’s domestic borrowing costs due to lower interest rates it is now possible to raise the level of public investment by at least 20 per cent compared to the current year’s actual utilization. Most of this investment should be in infrastructure and the social services sectors, with particular attention to the district and municipal levels.
GDP growth in FY02 is likely to range between 3 to 3.5 per cent — still lower than the long-term trend growth rate but higher than the previous year.
The shortage of irrigation water, which has worsened over the last two years, dampened the growth of agriculture for the second successive year in FY02. While the rice crop suffered fall, other major crops (e.g. cotton and sugarcane) were able to do better due to rains in early part of kharif that alleviated the water shortage from an anticipated 48 per cent to 18 per cent, as well as an increase in the area under cultivation.
The 22 per cent fall in rice production is markedly higher than the 14.1 per cent decline in the area under rice cultivation. This is explained by the replacement of a low-value variety of IRRI rice (high yielding) with a refined but low-yielding variety of basmati rice.
Notwithstanding the better harvests of cotton, sugarcane and wheat, much of the benefit to farmers is expected to be lost to lower prices. As a result, despite higher growth in the sector, farm incomes will not improve commensurately. The continuous fall in farm incomes since FY01 is aggravating rural poverty, reducing agricultural investment and raising agricultural credit requirements.
Thus, the FY02 entry of private sector commercial banks into the agricultural credit market is a very welcome new development. Together with NCBs, these banks can play an important role by extending developmental credit e.g. for the construction of godowns/silos. Investment in storage capacity, in particular, would help food grain losses and also protect farmers against large seasonal variation in the prices of agriculture produce (the latter has positive connotations for rural poverty alleviation as well).
Unfortunately, despite the improvement in the country’s macroeconomic fundamentals during the current year, the overall growth in large-scale manufacturing (LSM) was very narrowly based and remained much lower than the last year’s 7.6 per cent increase. In addition to the high-base effect, weak demand (both in domestic and international markets) and uncertainty following September 11 events affected industrial activities.
However, the textile sub-sector picked up in January with greater market access from the EU. This improvement is also reflected in the large quantum increase in the export of value-added items during July-March FY02. In addition, the production of petroleum products remained strong on account of full-year impact of the establishment of PARCO. On the other hand, fertilizer output declined due to the closure of Fauji Jordan’s DAP plant. Construction and engineering activities remained depressed, causing declines in the production of the related industries like steel, cement, etc.
Surprisingly, the automobile sector output declined significantly. The production of trucks, buses and tractors sagged for the second successive year, but unlike FY01, the production of cars and jeeps in FY02 increased by only 0.9 per cent. This was despite the favorable environment of robust demand, the appreciation of the rupee (lowering cost of imported components) and lower interest rates.
Federal government revenue remained under stress, as CBR tax collections were 4.8 per cent short of the thrice-revised July-March FY02 targets. Net collections witnessed a 2.5 per cent decline over the same period last year. A compositional break down shows that direct tax receipts were largely in line with the 14.2 per cent target for period, suggesting that the government’s effort to broaden tax base are paying dividends. However, the indirect taxes undermined this improvement.
The shortfall in overall tax collections was attributed to the following factors: (1) exceptionally high tax refunds totalled Rs62.9 billion, a stunning Rs18.4 billion (41.2 per cent) higher than for the corresponding period last year; (2) lower than expected growth of imports, GDP, and manufacturing; and (3) subdued inflation. Looking ahead, the target for tax collections remains challenging, as CBR has to collect over Rs48 billion per month on the average to meet the set target of Rs414.3 billion.
As in the past, developments in the external sector continued to have an important bearing on monetary aggregates and policy. The extraordinary growth in foreign currency inflows and foreign currency reserves, and the resulting strength of the rupee, allowed the SBP to ease monetary policy. It initially reduced the discount rate by 200 basis points, and then slashed it another 300 basis points post-September 11, bringing it down to a record low 9 per cent to offset the shocks to the economy.
A slowdown in private sector credit was not unexpected given the uncertainties emanating from global recession, border tensions and cancellation of export orders. However, a closer reading of the data suggests that the actual availability of funding for the private sector fell by a much lower amount.
Despite SBP’s proactive monetary management, SBP purchases, lower than the usual demand for credit by the private sector from commercial banks, and continued retirement of export finance credit and government (commodity operation) the banks remained flush with liquidity. The inability of banks to expand their lending base to cope with this liquidity rush, led to larger interest in government securities. Coupled with high NSS receipts and improved external financing, this helped the government draw down its SBP debt, allowing it to comfortably meet IMF mandated limits of NDA growth.
Although, the monetary base increased by 6.3 per cent during Q3-FY02 as against a contraction of 2 per cent during Q3-FY01, lower interest rates kept the inflation in check at around 3 per cent.
The money multiplier for July-March FY02 was 2.9 against the 3.0 for the last year. However, due to large increase in monetary base, money supply shot up to 9.34 per cent, which was more than double the last year’s growth of 4.3 per cent and marginally higher than the full year target of 9.1 per cent.
As explained above, the interbank money market remained liquid in the third quarter of the fiscal year, with SBP smoothing out any temporary shortages through OMOs. Banks piled into the T-bill and PIB auctions, in order to lock-in assets at higher yields.
Banks were unable to keep the momentum in the deposit growth during Q3-FY02. Specifically, banks ended with a nominal increase of Rs10 billion during the current quarter against a massive surge of Rs72.2 billion in Q2-FY02 and the Rs23.4 billion in the third quarter of FY01. This subdued performance was mainly attributed to decline in the foreign currency deposits, amidst the expectations of a stable rupee and low interests. The decline in the expected return on FCAs made the NSS instrument more attractive, as seen in the continuously rising net mobilization in the NSS.4
The higher deposit growth of the Q2-FY02, seasonal retirement against commodity operations, decline in net credit demanded by the private sector, and SBP foreign currency purchases (especially, from the interbank market), left the banks with excess liquidity. A liquid interbank market, decline in tax rates (w.e.f. 1st July 2001), and a slight reduction in NPLs and defaulted loans during July-March this year, enabled the banks to operate at a relatively lower banking spread. It is encouraging to note that overall weighted average lending rates recorded a decline by 145 basis points during Q3-FY02 against 45 basis point downward adjustments in deposit rates.
All the three price indices recorded lower increases in Q3-FY02. However, the deceleration was sharper in terms of WPI, which increased by only 0.4 per cent compared with 7.5 per cent last year. This was due to the relative comfortable supplies of agriculture produce (except rice), the appreciation of the rupee as well as decline in unit value of some imported items. However, the higher monetary expansion during the quarter coupled with increasing energy prices, may contribute to inflationary pressures in coming months.
The most noteworthy change in the external sector is the current account surplus of $2.1 billion during July-March FY02 against the deficit of $82 million in corresponding period last year. This surplus was achieved despite the lower kerb purchases, primarily on the basis of a reduced trade deficit (mainly due to lower international oil prices), a broad-based improvement in the services account, a surge in workers’ remittances and a heavy official transfers.
Notwithstanding the 2.7 per cent fall in export revenues, the trade balance improved by 38.1 per cent on the back of a marked reduction in the import bill to the tune of $685.6 million (8.5 per cent), primarily on account of lower import quantum of POL and their falling price in international market. In addition, sufficient stocks of refined sugar due to excessive imports of both raw and refined sugar last year coupled with better domestic production this season, almost eliminated the need for the import of this essential commodity (net saving of $195.3 million).
Exports, on the other hand, received a serious setback by the events of September 11 and subsequent hostilities in the region.5 The textile sector, the major contributor to export earnings, declined by 0.9 per cent over the same period last year. Nonetheless, despite lower prices, the rise in the quantum of textile exports is encouraging, particularly for value-added exports such as cotton fabrics, bed-ware, towels, readymade garments, tarpaulin and other canvas goods. The exports of knitwear, synthetic textiles, cotton bags & sacks and cotton yarn, on the other hand, declined markedly both in volume and value. Among the food items, rice exports suffered the most serious shortfall (17.1 per cent) and earned $332.2 million compared to $400.6 million last year (mainly due to lower export volumes).
As far as the capital account is concerned, the higher outflows during the period under review were primarily driven by the repayment of maturing 3-year Special US Dollar Bonds, the lower project aid from bilateral countries, the higher repayments of commercial loans/credit contracted in last year, accelerated repayments of institutional FE-45 deposits and the closure of swaps with various commercial banks. The more encouraging sign is the acceleration in foreign investment. This reflects the renewed interest of foreign investors due to the higher foreign exchange reserves and their confidence in the government’s commitment to the ongoing reforms agenda.
In terms of the exchange rate, the rupee remained stable during Q3-FY02. This stability was the upshot of SBP purchases from the interbank market that increased to $902 million during Q3-FY02 against $705.2 million in the previous quarter. This solicited cushion was provided in order to protect Pakistani exporters that had already suffered on account of the appreciating rupee (6.54 per cent to date) and cancellation of export orders.
This huge current account surplus6, together with increased inflows from IFIs helped in building up foreign exchange reserves to unprecedented level of $5,233.5 million by end-March FY02. Although the donors’ support to Pakistan to compensate for the negative economic impact imposed by Afghan war is prominent in this build-up, the reversal of capital flight and the stronger inflows of workers’ remittances cannot be overlooked.
In turn, with wider pool of reserves, SBP capitalized on this opportunity by settling short-term liabilities under swaps, short-term deposits and PTMA, which will ease the future cash flows for Pakistan. The comfortable reserve position and the narrowing of kerb premium have also provided an opportunity to consolidate the gains in remittances by enfolding the informal market into the official system. The first step in this regard will take place in July 2002, when exchange companies are to come into existence.
1By end-March 2002, the net receipts target for FY02 has been reduced by a cumulative Rs 43.5 billion.
2Weak custom duty receipts have been the primary cause of the tax shortfall in FY02.
3In essence, the worker’s remittances represent the ‘export’ of Pakistani services. Thus, the funds sent through the informal markets represent leakages that should correctly accrue to the formal economy. Plugging of these leakages through the FECs could thus lead to a sustained improvement in Pakistan’s current account.
4During Q3-FY02, net mobilization under NSS were Rs 23.4 billion against Rs 12.4 billion recorded in the last quarter.
5This is in addition to impact of continued global recession and falling unit export prices of Pakistan’s major export items.
6The current account surplus allowed the SBP to increase the SBP reserves.
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