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Inflation, exchange and interest rates By Mohiuddin Aazim - LahoreEstate - 11-23-2009 03:48 AM
VOLATILE exchange and interest rates impede economic progress. A fast weakening rupee and high interest rates in the last fiscal year had a hand in contracting economic growth. But this year the rupee seems to be somewhat stable and interest rates are slithering on falling inflation.
It is in this background that the State Bank of Pakistan is to announce its fresh monetary policy stance tomorrow. Indications are that the central bank would reduce its key policy rate by 50-100 basis points depending upon how it interprets the declining inflation and whether it sees the trend continuing.
Headline CPI inflation that had peaked at 25 per cent in October 2008 fell gradually month after month and plunged to 8.9 per cent in October 2009. Annualised average inflation that had zoomed to 24.6 in July-October FY09 came down to 10.2 per cent in July-October FY10. This gives the State Bank a solid reason to go for another policy rate cut. The SBP cut the rate from 15 per cent in November 2008 to 14 in April and to 13 per cent in August 2009. Much has changed on the economic front since August 17 when the central bank had last lowered the rate.
“The declining inflation trend that was in sight in August has become a bit firmer,” said a senior economist at SBP but avoided to comment on whether the central bank would lower its discount rate now—and if so by how many percentage points.
“We also have to look at whether inflationary expectations have eased—and whether they have softened enough to facilitate a new rate-cut.”
Inflationary expectations do not necessarily build up or weaken precisely in line with the trend in inflation. The factors that can affect future movements in inflation, may shape them up.
Besides, non-monetary phenomena like good governance, political stability, corruption and supply shocks (like the continuing sugar crisis) also impact on inflationary expectations.
“We believe inflationary expectations are still there and that is something a central bank takes into account before changing its monetary stance,” said another SBP economist involved in monetary policy formulation.
But economists at the central bank also say the SBP mandate requires that it should keep a fine balance between price stability and growth. In the last fiscal year, GDP growth rate slipped to just two per cent from 4.1 per cent a year earlier and the government has set a growth target of 3.3 per cent for the current fiscal year.
The domestic economy has so far exhibited some signs of recovery but its pace needs to be accelerated to achieve the growth target and that is not possible without a significant reduction in banks’ interest rates. So there is a case for reducing the SBP policy rate.
The average lending rate of banks slipped to 13.67 in September 2009 from 14.02 per cent in June 2008. “A real recovery of business and industry is not possible unless the rate comes down to 10 per cent,” suggests Mr S. M. Muneer, ex-president of the Federation of Pakistan Chambers of Commerce and Industry.
Top bankers say if the SBP goes for a 50-100 basis points cut in discount rate it might lead to a 25-50 bps decline in banks’ average lending rate—and that too over three months. This lagged effect of policy rate cut makes the case for a fresh rate cut stronger.
Businessmen point out that six-month KIBOR rate, which serves as a base rate for pricing the largest chunk of short-term and medium-term bank loans, closed at 12.75 per cent on November 16. “There is a need for at least a 100bps cut in SBP discount rate to reduce it. Without a cut, the effective lending rates of banks would not fall,” says Mr Iqbal Ibrahim, a textile tycoon.
Businessmen seek stability in exchange rate saying it keeps prices of imported items from rising due to rupee depreciation thus benefiting not only the economy in general but also the exporters who use a lot of imported stuff in producing exportable surplus.
Since the beginning of this fiscal year, the rupee has so far lost around 2.5 per cent of its value against the dollar and the pace of its depreciation is unlikely to accelerate in coming months because of continued foreign capital and financial inflows. These include IMF support, partial release of Coalition support fund from the US, part fulfillment of the financial pledges made by Friends of Democratic Pakistan,, exceptionally strong inflows of workers’ remittances, return of portfolio investment and a possible pick-up in exports and foreign direct investment from the second half of the fiscal year.
The current rupee stability has helped in containing imported inflation and weakening inflationary expectations. Bankers anticipate that the trend would continue throughout this fiscal year and the national unit would not depreciate more than 7.0-7.5 per cent during the whole of this fiscal year against 19.5 per cent in the last year. Businessmen verify that bankers are pricing forward foreign exchange covers in line with this anticipation.
However, all is not well. The declining trend in inflation may pause in the second half of this fiscal year when power tariff would be raised by 19.5 per cent in two phases. This may become more likely if fuel oil prices rise further (though its possibility remains low). Much would depend on how food prices move both in the international as well as domestic market. Till now food prices are on the decline both internationally as well as domestically with the exception of sugar. However, home sugar prices are set to decline in coming weeks as sugarcane crushing has partly started and all sugar mills would begin crushing in December.
On fiscal side, the government has so far managed to retire inflationary borrowings from the central bank and its non-bank borrowing particularly through National Saving Schemes has been on the rise. But the cost of the war on terror is going to take a toll on financial resources availability. To trade it off, the government has decided to launch an austerity campaign aimed at reducing non-development spending and development expenses too have already been cut.
“If inflation starts inching up in the second half of the current fiscal year making it difficult for the central bank to lower its policy rate, then the effective lending rates of banks would remain high” said a senior SBP official. But he was upbeat about the prospects of exchange rate stability.
A 26 per cent fall in imports in the first four months of the current fiscal year against only nine per cent decline in exports has cut the trade deficit by 41 per cent.
And foreign exchange reserves have stabilised around $14.2 billion plus or equal to a little less than six months of imports, up from $12.4 billion at the end of the last fiscal year, providing the SBP with enough cushion to smooth out volatilities in the exchange rate
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