KARACHI, Dec 21: The International Monetary Fund or IMF has recommended that the State Bank monetary policy should focus "primarily on curbing inflation, as it is currently pursuing too many objectives."

The IMF says in a recent review of Pakistan economy that while annual average inflation is still in single digit, the increase in inflation could fuel inflation expectations. "If left unchecked, a harsher tightening (of the monetary policy) will be required later on, with more adverse effects on growth."

"While inflation appears to have levelled off in the last three months (July-September), the (IMF) staff urges the SBP to tighten monetary policy more forcefully," says the IMF in the Ninth Review under the PRGF or Poverty Reduction & Growth Facility.

The review had laid the basis for the release of $262 million final tranche of the three-year PRGF but Pakistan decided not to draw it and ended the programme ahead of schedule.

Pakistan had initially set inflation target at 5 per cent for this fiscal year, up from 4.57 per cent in the last year keeping in view its GDP growth target of 6.6 per cent, up from 6.4 per cent in the last year.

But year-on-year inflation moved much faster than anticipated right from the start of the new fiscal year in July and it shot up to 9.1 per cent year-on-year in July-November 2004.

This has occurred despite a gradual hiking of interest rates by the central bank but many see this tightening a bit slower than required to rein in the galloping inflation.

The Fund recognizes the fact that the State Bank's monetary policy is geared to both control inflation and support growth. "In addition, exchange market intervention is geared at maintaining competitiveness and limiting fluctuations of the exchange rate of the Pakistani rupee."

The Fund also recognizes the fact that the SBP has stepped up its efforts to stem inflation. "The SBP started to raise interest rates in October 2003 but it initially did so in very small steps, in order not to choke off the economic recovery.

The SBP initially felt that inflation was largely the result of supply-side factors and not easy monetary conditions, so that a tightening would not be effective."

In doing so, the central bank was not off the mark because inflation was rising due to higher food prices and more expensive rents for housing units, in the first case due to shortage of and mismanagement in handling the supply of food items and in the second case because of speculative investment in land. The central bank introduced a 50 per cent margin on wheat financing and stopped banks from lending money for the mere purchase of land to tackle the two issues.

Underlying the need for a tighter monetary policy to contain inflation, the IMF says a tighter monetary stance should also alleviate pressures on the exchange and reduce the need for exchange market interventions. "The SBP has allowed some greater nominal exchange rate flexibility in recent years, while trying to limit volatility in the market," notes the IMF report.

The central bank "has also monitored closely Pakistan's real effective exchange rate with a view to maintaining competitiveness. This approach has contributed to the recovery of the confidence in the Pakistani rupee, export-led growth and strong foreign exchange reserves."

The IMF staff note in the report that if "substantial pressures were to arise in the foreign exchange market, additional exchange rate flexibility could relieve pressures on monetary policy."

The staff further notes that, assuming a broadly unchanged real exchange rate, progress will continue to be made toward achieving external sustainability. "Exports and imports will continue to grow strongly, with the current account shifting into a small deficit.

Exports will benefit from the expanding world economy and possibly from the end of the textile quota system, while imports will increase due to strong domestic demand." But the IMF report warns that external competitiveness will need to be monitored closely, in view of the uncertainties related to the removal of the textile quotas.

It says that the SBP is projected to accumulate reserves for 2004/05 as a whole, "but at a slower pace than in the past few years." Whereas the IMF report (relying mostly on July-September statistics) points to the possibility of strong growth in both exports and imports, July-November 2004 data show that imports have grown much faster than exports during this period.

In five months to November 2004, exports rose by 11.06 per cent to $5.37 billion but imports shot up by 49.27 per cent to $7.882 billion. As a result, the trade deficit swelled to $2.511 billion from only $444 million in a year-ago period.

This suggests that Pakistan would see a sizable current account deficit during this fiscal year. This seems a likely scenario also because, workers' remittances or foreign exchange sent back home by overseas Pakistanis, have also shown only a modest growth. In five months to November 2004, Net workers' remittances rose by 9.8 per cent to $1.607 billion.