January 30, 2006	Monday	Zilhaj 29, 1426

The State Bank of Pakistan’s six monthly monetary policy statement released this past week delivered the expected. Dr Shamshad Akhtar, the new central bank governor, said in her first monetary policy statement that the tight monetary policy regime initiated in early 2005 would continue as the battle against inflation forges ahead and even further tightening may be necessitated if inflationary pressures do not fade.

Many raced to the conclusion that further monetary tightening had been announced. Given the proliferation of new financial experts on all variety of television channels, this was worrying given the potentially powerful effect the media can have on the markets. The SBPs policy was, from its statement, clear and unambiguous: policy would remain tight and would only be tightened further if price stability was threatened. A markedly different conclusion.

The State Bank announces its monetary policy stance every six months with the purpose of ensure stability and predictability in the economy in order to enable investors to make effective investment decisions. The release of the policy statement is preceded by two key meetings where credit matters for the six months gone by are reviewed.

The meetings of the National Credit Consultative Committee and the Agriculture Credit Consultative Committee resulted this time in three major positive developments. First, the new SBP governor underscored the need to hold the NCCC meeting well in advance of the issue of the monetary policy statement to enable sufficient time in the decision making process including feedback from the private sector and stakeholders. This is welcome since invaluable suggestions from different sectors can aid in the formulation of policy.

She also raised concerns about the widening interest rate spread and said depositors must gain from the rising rates too. This too is a relief since a major concern rages about the disincentive to save in the current monetary environment and the implicit ongoing transfer of wealth from savers to borrowers. This is particularly of concern since older worries about a low national savings rate still persist despite economic improvements in the last few years.

Lastly, even though agriculture credit disbursement grew 25 per cent in the first six months of the fiscal year compared to the same period last year, Dr Akhtar reemphasized the need to develop agriculture credit as a business line and not leave it as a task relegated to the state-run Zarai Taraqiati Bank. She said a plan would be developed that would aim to increase access to credit to 3.3 million rural households within the next three to five years. Currently, only 15 per cent of the potential market of 6.6 million rural households have access to agriculture credit. Given the chronic poverty in farming communities in rural Pakistan, this is a positive policy plan and one, it is hoped, will be followed through on with aggression.

However, the SBP also said in its monetary policy statement that rising bank credit to agriculture and SMEs will help with poverty alleviation. The problem here is that monetary policy is primarily a tool to create predictability in the economy while other tools such as fiscal policy and the Public Sector Development Plan are more effective methods to target poverty alleviation. Moreover, access to credit has to be far more wide-ranging for both SMEs and the farming community and has to be accompanied by an effective use of other more targeted policy tools.

Inflation and interest rate outlook: The SBP reiterated in its monetary policy statement the need to balance the twin aims of price stability and continued GDP growth and said the supply of money would have to be controlled in order to achieve both objectives without compromising on either one.

Economists do not expect the government to meet its seven per cent GDP growth target this fiscal year and the State Bank also indicated in its monetary policy statement that a slowdown in some industrial sectors and in agriculture growth will lead to lower GDP growth. Growth will moderate significantly from 8.4 per cent last year, the highest in two decades and the SBP said both large-scale manufacturing and agriculture will miss this years targets and even though services will grow well, GDP growth will also miss its target this year.

The SBP first initiated monetary tightening in early 2005 when food inflation hit a high of 15.7 per cent in April and headline inflation as measured by the consumer price index (CPI) was recorded at 11 per cent. When the last fiscal year ended on June 30, 2005, CPI had hit 9.28 per cent, the highest level in eight years compared to 4.6 per cent the previous year. By the end of June, the SBP had raised interest rates sharply, taking the discount rate (the rate at which banks borrow from the central bank) up from 7.5 per cent to nine per cent for the first time since November 2002. The cut-off yield on the six month Treasury bill also rose by 414 basis points in the first six months of 2005. In the second half of the calendar year, the tightening moderated and the cut-off yield on T-bills rose just 30 basis points.

By December 2005, CPI moderated to 8.5 per cent and food inflation fell to 8.1 per cent but core inflation (non food, non fuel) fell only from 7.6 per cent to 7.4 per cent during the period. Why has core inflation exhibited sure signs of rigidity?

Food supply chain problems are one answer. The SBP says there have been improvements in the way the government handles food supply by ensuring imports of essential commodities. That may be so and healthy wheat and rice crops will also help. However the SBP does not mention the strong prevalence of cartels and monopolistic behaviour across a range of industries as well as the predominance of hoarding and profiteering for which no real checking mechanism has been developed.

Clearly, inflationary worries are far from over. However, most analysts agree that the SBP will maintain the discount rate at the current three-year high of nine per cent for the next few months. The yield on six-month T-bills is also unlikely to move drastically from its four-year high of 8.29 per cent.

However, a sharp rise in private sector credit offtake to almost Rs 300 billion could be a potentially major worry. In the first six months of the fiscal year, private sector credit amounted to almost Rs 300 billion indicating that the full year target of Rs 330 billion will be overshot. The hope still is that private sector credit offtake will be contained below Rs 340 billion, allowing for a year-on-year growth of some 20 per cent, considered a healthy level by analysts. The SBP said in its statement that the credit boom may decelerate as lending rates rise further this year. Government borrowing for budgetary support has also jumped to Rs 78.3 billion from Rs 25 billion in the same period last year on account of earthquake-related relief spending.

However, a major concern continues to be the limited understanding about or information on the link, transfer mechanism and lags involved in the relationship between interest rate adjustments and the rate of inflation. Dr Akhtar would do well to ensure research is now conducted on this topic in particular so that the effectiveness of strategy is tested in real time. The SBP also said in its statement that inflationary pressures will persist from large fiscal imbalances and a widening trade deficit, the risk of rising oil prices and the risk of upward pressure on wages due to recent growth.

Trade and current account deficits certainly pose problems. The trade deficit has ballooned by 66 per cent to $3.8 billion (SBP figuires) in the first half of the ongoing fiscal year as imports of oil, machinery, raw materials and consumer goods such as automobiles rose. While rising foreign aid, strong inflow of remittances and foreign direct investment flows will help bridge some of the gap, the rest will have to be accommodated through the drawing down of reserves and the adjustment of the exchange rate. The latter, many analysts argue, has long been overvalued and some analysts forecast the central bank will have to gradually devalue the currency by up to three per cent in the next six months to support the widening current account deficit.

All in all, no real surprises in the monetary policy statement. It restated the need to keep policy tight in line with regional strategy and global inflationary concerns. The key factors to watch in the next six months will be whether food inflation continues to decline, whether the government is able to dent core inflation and if neither happens, how quickly and effectively the SBP responds.