KARACHI, Feb 21: A sharp increase in currency in circulation (CiC) threatens to push inflation further up in the remaining five months of this fiscal year.

Inflation measured by Consumer Price Index rose 3.38 per cent in seven months to January 2004 against the upwardly revised target of 4.2 per cent for the full fiscal year.

The latest State Bank data shows that currency in circulation or currency outside the banking system expanded by Rs43 billion in January 2004 alone.

Central bankers do admit that this high pace of increase in CiC may take toll on inflation in February. They say that this huge expansion in CiC is attributable chiefly to pre-Eidul Azha withdrawals of money from banks. Since Eidul Azha fell on February 2 people took out billions of money from banks to buy sacrificial animals and finance other Eid related expenses in late January. "That is why currency in circulation shot up last month," said a senior central banker adding that a major chunk of the money withdrawn before Eidul Azha should return to the banking system by middle of March, thus contracting the volume of CiC.

But central bankers do agree that a big increase in CiC, even if short-lived, threatens to push up inflation. Bankers fear that unlike in the past when the money withdrawn from banks before Eidul Fitr or Eidul Azha used to return to the banking system after six-eight weeks, this time the trend may change. "A major chunk of this money may remain outside the system for quite some time," said treasurer of a local bank citing low rates of return on bank deposits.

"If banks give two per cent return on one-year deposits many people will find it more tempting to invest money in speculative yet more attractive areas," the banker said. Most local and foreign banks offered 1-2 per cent return on one-year deposits in July-December 2003 against inflation of 3.08 per cent during that period.

Humiliatingly low rate of return on bank deposits is driving many people to hold more cash than in the past through various means. Many of them are making investment in euro and pound sterling and a big chunk of the money thus invested is not returning to the banking system - thanks to currency smuggling by some money changers.

In the recent past, the SBP took action against several such money changers. Sources at currency exchange houses say currency smuggling from Pakistan to Dubai has become so rampant that the Rs100 and higher denominations of Pakistani currency are commonly acceptable for personal transactions between Pakistanis living in certain parts of Dubai.

Sources at Karachi Stock Exchange say at the time of initial public offerings of hot scrips many people buy multiple lots of shares in the name of other persons. They do take out money from their bank accounts and finance purchase of shares by other people on their behalf. Since a big number of those whose bank accounts are used for this purpose are not taxpayers, the original investors than start using these accounts for future transactions in the non-documented sector. That is also a reason for increase in CiC.

Bankers say inflation seems set to rise beyond four per cent not only due to increase in CiC which is bound to result in price-hike, but also due to overall increase in broad money or M2. In a little more than seven months i.e. between July 1 2003 and February 7, 2004, M2 expanded by 10.8 per cent against the full fiscal year target of 11.06 per cent. Central bankers say privately that the growth in M2 cannot be contained within the targeted level by the end of this fiscal year in June. What makes it more likely that the M2 growth would increase inflationary pressure is that M2 has grown almost entirely due to increase in net domestic assets of the banking system - and more precisely due to a very large increase in the private sector credit disbursement.

Between July 1, 2003 and February 7, 2004, commercial banks disbursed Rs219.6 billion credit to the private sector. In a year-ago period, they had disbursed Rs69.8 billion. The private sector credit offtake in this fiscal year so far has been much higher than in the comparable period of last fiscal year for several reasons, including higher lending to small and medium enterprises and consumer financing. Figures for SMEs and consumer financing up to February 7, 2004 are yet to pour in, but data pertaining to July-December 2003 show that banks made Rs75 billion loans in these two sectors.