Inflation still poses a threat: SBP

KARACHI The State Bank of Pakistan has kept the policy rate unchanged at 12.5 per cent for the next two months (February-March) of current 2009-10 financial year due to expected persistence in inflationary pressures and to maintain trade-off between positive macroeconomic developments and ongoing economic challenges.
This was stated by SBP Governor Syed Salim Raza while unveiling the Monetary Policy statement at a Press conference held at Bank premises on Saturday.
Raza said macroeconomic stability has proceeded apace, as evident in the considerable decline in average Consumer Price Index inflation - which is the primary objective of monetary policy.
In the first half of the current 2009-10 fiscal year (FY-10) inflation recorded at 10.3 per cent, compared to 24.4 per cent during H1-FY09, he said and, added that this decline is visible across almost all the subgroups of CPI.
The inflation outlook for full FY10, nevertheless, remains somewhat vulnerable to the effects of fiscal consolidation efforts and to incipient international commodity price pressures, he said and, added that the Bank expects the average CPI inflation for FY10 to remain between 11 and 12 per cent, still much lower than the 20.8 per cent inflation of last year, but higher than the 10.3 per cent recorded in the first half of FY10.
To maintain price stability, we are pursuing a very cautious monetary policy stance as at the short term, we would want to see a reversion of the current inflationary uptick, and a more certain outlook for systems liquidity, he said.
Assuming the revised financial inflows are realised, the SBPs foreign exchange reserves are projected to reach close to $15 billion by the end of FY10, he added.
He said uncertainty regarding availability of external financial inflows, non- resolution of circular debt and upward reversal in the international commodity prices would pose serous risk to the macroeconomic stability.
Talking about the real economy, Raza said that the agriculture sector has shown improvement and the wheat crop was good with higher prices stimulating demand for consumer goods, and the cotton crop higher than last year improving textile production and corresponding exports.
Modest but consistent recovery in Large-scale Manufacturing (LSM) is also encouraging, he said and, added that the LSM grew by 0.7 per cent in November 2009 compared to a low of negative 20 per cent in March 2009. Revival in private sector credit and better-than-expected global recovery should further support economic growth, he added.
Assuming that the current trend in LSM growth continues, SBP Governor said that the overall real GDP growth is expected to be 3.0-3.5 per cent in FY10, as compared to 2.0 per cent in FY09.
Referring to external current account, he said that progress in the external sector is also encouraging. The external current account deficit has declined to $2 billion during H1-FY10 from $7.8 billion in H1-FY09. A small decline in exports was substantially offset by a higher decline in imports resulting in significant reduction in the trade deficit, he said and added the sustained flow of workers remittances ($4.5 billion during H1-FY10) has further contributed to the reduction of the external current account deficit.
External current account deficit is projected at 3.4 per cent of GDP for FY10-a significant improvement over last years deficit of 5.6 per cent and earlier projections of close to 5 per cent, he emphasised.
He said that as a result of significant contraction in the external current account deficit, the overall balance of payments has posted a surplus of $1.4 billion during H1-FY10 compared to a deficit of $4.8 billion in H1-FY09.
A modest increase in foreign portfolio investment, additional SDR allocation, and SBA flows from IMF, more than compensated for the decline in foreign direct investment, he added.
However, he said sustained improvement in the balance of payments would depend significantly on the timing and scale of projected foreign inflows, especially the official flows pledged in Tokyo by the Friends of Democratic Pakistan (FODP).
On the fiscal front, Fahim Raza said that the Federal Government has continued efforts for rationalising expenditures, by phasing out subsidies and by adjusting the administered energy prices.
'It has also taken in hand the organisational and administrative measures to bolster tax administration and revenue collection, he added.
Raza said the State Bank has managed systems liquidity to both support smooth functioning of the market and to do this consistent with the monetary policy stance.
'As a consequence, volatility in the interbank overnight money market Repo Rate - the operational target of SBP - has come down substantially and market interest rates have gradually eased in line with reduction in the policy rate, he added.
'Integrating projections for balance of payments, fiscal accounts, and credit growth and given their interrelationships with inflation and real GDP projections, the equilibrium M2 growth is forecasted to be around 14.5 per cent for FY10, he added.
While summing up the overall macroeconomic scenario, he said that much has been gained with respect to macroeconomic stability front on a challenging economic and security environment.
Difficult decisions have been taken and adjustments were made to address a host of structural constraints, he asserted.
He warned that the most prominent risk to macroeconomic stability is the uncertainty regarding availability of external financial inflows, which has the deep effects on both fiscal accounts and the external current account sustainability.
'It also has implications for future trends in both the accounts and other sectors of the economy. As already explained elsewhere in the document, less than required inflows or a mix of financial inflows skewed towards debt creating flows, particularly of short term nature, would reduce fiscal space and jeopardise financing of the current account deficit.
The challenge, in the first place, is to address the underlying causes for such uncertainties and build capacity to forestall its ramifications, he added.
He said the ideal solution is to increase the economys resource envelope to meet the requirements of a growing economy. The second best solution, however, is to live within the resources available.
In absence of adequate resources, the onus of macroeconomic stability also falls on timely adjustment of relative prices i.e. interest rate and the exchange rate, he added.
'These prices should be allowed to adjust in time since a delayed adjustment only tends to waste resources.
'Second most prominent risk to the economy is the extent of impetus received from the global economic recovery. The fruits of growth in the global economy cannot be reaped fully if the increase in domestic productive capacity and the depth of financial markets is not commensurate with the demand created for exports or to absorb financial inflows, respectively. These require removal of bottlenecks related to the improvement of law and order situation, infrastructure development, continuation of reforms process and increase in financial sector depth, he informed.
He said linked with the global recovery, recurrence of rising international commodity prices trend poses another risk to the economy.
Given its widespread impact on the economy, the real challenge is to ensure a transparent pass-through of its effect to the economy so that it adjusts to them in full and in time, he added.
He further said that the absence of transparency and any artificial delay in adjustment would impair pass-through and bring complacency among economic agents.
The circular debt issue poses a threat to the stability of institutions both in the power sector and financial sectors, he said.
'Moreover, it is distorting the pricing of assets in the banking sector, and weakening the pricing mechanism and transmission of monetary policy changes. There is need to address the root cause of this issue, which is timely generation of resources by institutions and payments by the government, in its entirety and without delays, he added.