Interest and exchange rate management is expected to be a bit more challenging this year owing to a rising trade deficit and pressure on the external balance of payments position.

It will be interesting to see how the State Bank of Pakistan factors in emerging ground realities in its monetary policy and how banks respond to policy signals.

Government borrowing from banks is expected to remain high; stock and real estate markets likely to grow; a squeeze in currency in circulation seems a possibility. The government cannot boost its non-bank borrowing dramatically and banks’ appetite for higher interest income is sure to remain strong.

Net forex inflows are being projected to grow though this optimism needs a reality check. Although banks and forex companies enter 2017 with greater discipline, attempts of money laundering and capital flights cannot be ruled out. This, by and large, summarises how top bankers and stockbrokers look at the key factors that would weigh on interest and exchange rate management.

“Average non-food, non-energy (NFNE) has been on the rise since July 2016, impacting headline inflation, and the trend may continue as domestic demand is growing and as constraints in supplies remain in sight,” says the head of one of the top five banks.

Even trimmed inflation, another measure of core inflation other than NFNE, has been only a shade below the headline inflation of around 4pc and may well move up along with it, due to higher fuel, oil and food and non-food prices. The central bank may have to halt continuation of its loose monetary policy, senior bankers argue.

“But, if the squeeze on currency in circulation (CiC) and lower growth of reserve money (RM) seen since the beginning of July last year are sustained to some extent, the case for tightening the monetary policy will be weakened,” opines an official of the Pakistan Banks Association.

From the banks’ viewpoint, monetary tightening during this year could be helpful for them. They have gone through years of easy monetary policy, living on low banking spreads.

In the last three years (between November 2013 and November 2016), the banking spread has declined from 3.47pc to 2.64pc.

“This spread is now just too low and if it remains intact or falls further, it would seriously hurt the banks’ profitability,” says the treasurer of a large local bank.

In the third quarter of 2016, banking sector profit has already declined by 4pc and their net interest income fallen by 5pc. The fourth quarter results will be no better, senior bank executives warn.

Over the years the SBP has improved the mechanism for effective transmission of monetary policy signals by introducing an interest rate corridor and by asking banks to offer a minimum return on deposits. Ideally this should have made banks efficient enough to continue to remain profitable even during a long period of lax or stable monetary policy. On the surface this has happened.

But the reason why banks have now started feeling uncomfortable with the easy monetary policy is that recently the government has been borrowing less from high-yielding long-term Pakistan Investment Bonds (PIB) and the retirement of PIBs has created problems for those banks that had invested heavily in them, central bankers point out.

So, from banks’ point of view the more important area is the government’s debt raising policy. The government has already set a high bank borrowing target for fiscal year 2017 ending in June. But whether it will also borrow heavily in the next fiscal year from July 2017 onwards is hard to predict.

If the government borrowing during the first half of 2017 remains below the target, or if it borrows modestly in the second half of the year, banks would be in trouble because they have grown used to making money via over-investment in government debt papers. Interest rate management by banks in this context looks difficult this year.

Exchange rate outlook

Inter-bank exchange rates were quite stable in the outgoing year and the rupee rather remained overvalued by 1.38pc and 1.63pc respectively as measured by nominal and real effective exchange rates, NEER and REER.

“So we can expect some weakening of the rupee vis-à-vis the dollar in 2017 but that would depend chiefly on market demand and supply,” says the treasurer of a foreign bank, adding that greater discipline enforced in the forex market now leaves little room for currency manipulation by banks.

The central bank can still facilitate a desired decline in rupee value by choosing timings and volumes for buying dollars from banks on quarter-end foreign debt payments on behalf of the government.

“Bulky fuel oil import bills can also weigh greatly on exchange rate movements, more so because of the recent growing trend in international oil prices.”

Balance of payments woes are going to subside in 2017, officials of the ministry of finance say.

Both foreign direct investment and portfolio investment are expected to rise as the CPEC inflows grow fatter and as the strategic sale of 40pc stakes of the Pakistan Stock Exchange materialises and begins to attract more foreign investors.

Home remittances are growing though at a slower pace than seen in previous years.

“Any further slippage on the exports and remittances front, or any unusual repatriation of foreign funds from Pakistan, can have an impact on exchange rates and weaken the rupee,” says the former president of a state-run bank.

Published in Dawn, Business & Finance weekly, January 9th, 2017

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