KARACHI, March 30: Huge foreign exchange inflows causing inflationary pressure has created challenge for State Bank to manage the excess liquidity that may lead to further tightening of monetary policy.

The central bank on Friday issued second quarterly report for 2006-07 with serious concerns over rising growth of reserve money and inflation.

“This high growth in reserve money does not bode well as it dilutes the impact of monetary tightening,” said the report.

“A concern for SBP’s monetary policy is the sharp rise of 15.3 per cent in reserve money during July-Feb FY07 compared to 9.6 per cent growth realised during the corresponding period of the previous year.

The reserve money is the most inflationary source of monetary growth that potentially weakens the expectations channel of monetary policy transmission, said SBP report.

The report went on saying that the strong private sector credit demand and consequent availability of lending avenues suggest that a further rise in discount rate would have required to make banks’ investment in government papers more attractive, thereby reducing the reserve money growth.

The report further explained that at the current rate, banks had limited incentives to lend to the government given (1) a widening spread between benchmark rates for corporate lending and the repo rate on government securities; (2) absence of major risks on quality of private sector credit as evident from a decline in net NPLs to net loans ratio, and (3) more than required capital adequacy of banks.

Though the rising reserve money growth was making the monetary policy more challenging and difficult, the SBP had different reason not to increase the discount rate further high.

“Given the need to support private sector credit demand, rise in discount rate and further tightening of the market liquidity was not desirable,” said the report.

Analysts suggest that SBP’s effort has been failing to curtail the inflation coming through the hike of reserves money as the inflation is above the target and the SBP has used its maximum limit to increase the discount rate.

They said further tightening would be counterproductive and it would boost the inflation.

The report said that while the prospects of increasing investment is a necessary factor, it is equally important for policymakers to address economic stress points, such as the high inflation, large current account deficit, fiscal risks (such as the low tax-to-GDP ratio) and low savings rates.

The current account deficit is projected to widen during FY07 as, despite a sharp fall, growth in imports remains higher than that of exports. However, as the economy continues to expand strongly, this does not pose a significant macroeconomic risk in the short term, particularly due to availability of debt on favorable terms and strong investment flows, said the SBP.

Growth in credit to private sector decelerated during July-Feb FY07, rising by 10.7 per cent compared with the growth of 18.1 per cent during the same period last year.

The State Bank says that the slowdown primarily stems from a deceleration in fixed investment loans (particularly in the textile sector), as the working capital requirements have actually accelerated.

Delays in initiation of major infrastructure projects like power projects, led to subdued demand for fixed investment loans. Credit growth is expected to accelerate as structural factors are resolved and the infrastructure projects come online.

The credit to agriculture sector also declined. The report said the agriculture credit disbursement during FY07 was expected to decelerate from the exceptional levels in the past three years. This is implicit in the 16.4 per cent disbursement growth target for the year, as compared to the 26.4 per cent rise in FY06. However, the 13.0 per cent rise seen during July-Jan FY07 is much weaker than anticipated.

A sector wise analysis of the data shows that within business sector, the major slowdown came from the commerce and trade sector, the growth of which was only one third of the growth in the preceding year.

Further the growth in personal sector advances during July-Jan FY07 was almost half the growth the same period last year.

Within personal loans, all the consumer financing products registered slowdown, with loans for consumer durables showing net retirements.

The maturing of earlier consumer loans means that deceleration in net growth in consumer credit was to be expected. But the magnitude of the deceleration in FY07 suggests that the over all consumer credit demand has also moderated somewhat.

Auto loans during Jul-Jan FY07 were less than half that during July-Jan FY06 attributed mainly to increase in interest rates.