two sides of the same coin


The State Bank of Pakistan (SBP) is due to announce its interest rate stance on August 22, 2022.

Recent polls indicate that most market participants expect a status quo decision to keep the policy rate at 15%. This is accompanied by a view that interest rates have peaked and will eventually start to decline towards the end of the current fiscal year.

The SBP’s decision will depend on which data points it chooses to focus on. In the latest Monetary Policy Statement (MPS), the SBP said it would monitor fiscal/external deficits, monthly changes in inflation and global commodities as these would determine future price expectations. He had noted that the real sector was showing resilience (sales of cement, autos and oil were up) and that LSM’s growth was strong.

The external sector remained difficult with a higher current account deficit, driven by energy imports, although the completion of the IMF review would lead to an accumulation of foreign exchange reserves and currency stability.

At the same time, fiscal policy had become unexpectedly expansionary (petrol/electricity subsidies) with a primary deficit doubling compared to last year. Credit to the private sector continued to grow with increased demand for fixed investment and consumer loans.

Inflationary pressures had spread and were likely to remain elevated at 18-20% on average due to supply shocks. As a result, the MPC decided to increase the policy rate by an additional 1.25%.

The case of stability

If the SBP wants to push a narrative that further monetary tightening is unnecessary, it is likely to highlight the following developments:

Sharp drop in high frequency economic indicators. Sales of cement, cars and petroleum products fell 45%, 52% and 26% respectively compared to last year. Similarly, the monthly import bill fell 13% to $4.9 billion in July.

This indicates that demand destruction has occurred at a rapid pace, which would translate into slower growth and ultimately lower inflation.

While the Wholesale Price Index (WPI) rose significantly year-over-year, on a monthly basis it remained flat, indicating that supply-side pressures may be easing . Likewise, real interest rates on the basis of underlying inflation always remain positive.

The government removed subsidies for electricity and gasoline, which would lead to lower consumption and consolidate the precarious budgetary situation. New taxes have been imposed in the budget that target a primary surplus.

With a more restrictive/sustainable fiscal policy, there is little need to tighten financial conditions further.

Crude oil prices are down 5% since the last rate hike and with fears of a global recession setting in, the outlook for commodities is brighter for a net importer like Pakistan. This should ease the pressure on the trade deficit.

The IMF review is nearing completion and board approval is expected on August 29. This should unlock further multilateral/bilateral flows, halt the decline in foreign exchange reserves and stabilize the currency.

In fact, since peaking at 240, the PKR has recovered more than 10% against the USD as fears of a default fade. Eurobond yields and the credit default spread for Pakistan reflect this improvement in sentiment, as they have fallen sharply in recent weeks.

Finally, Treasury bill market yields are more in line with the policy rate than they were last year. Longer-term bonds are actually trading well below 15%, indicating expectations of slower growth and inflation ahead. So the SBP can rest easy knowing the market hasn’t outpaced them.

Why tighten more?

On the other hand, if the SBP wants to justify raising interest rates, it can focus on:

Inflation in July was higher than expected at 24.9% (4.4% m/m), core inflation continues to rise while the WPI saw a rise of 38.5% vs. compared to last year. The SPI is up 7.7% since the last MPS and 42.3% year-on-year. With CPI yet to peak and upside inflation risks intact, real interest rates of -10% are not sustainable.

The decline in sales in various sectors and imports is exaggerated due to one-off circumstances such as heavy rains, Eid holidays and temporary administrative measures. Given the presence of a large monetary economy, the demand for hard commodities will continue and must be reduced.

Fiscal consolidation will require further increases in electricity and gas tariffs, while the government has pledged to pay Rs 50/litre PDL on petrol and diesel. These supply shocks risk further entrenching inflationary expectations, which can only be moderated by higher rates.

With a record budget deficit of Rs 5.5 trillion in FY22 and the short-term nature of government borrowing, the SBP will need to remain hawkish.

Broader commodities have rebounded an average of 10% since early July (as indicated by the Bloomberg Commodities Index) and geopolitical uncertainties have heightened, raising the risk of extreme events that could derail the incipient recovery of macroeconomic stability.

Foreign exchange reserves have fallen 19.6% in the current fiscal year and provide barely a month’s worth of import cover. The government is required to build up reserves for up to 2.2 months of import cover, finance a current account deficit equal to 3% of GDP, and ensure the repayment/renewal of the $21 billion debt .

While the US Federal Reserve is expected to raise interest rates and the dollar appreciates (the DXY index is up 15% over the last 12 months), the SBP must slow down domestic dollarization by offering savers more attractive deposit rates.

Credibility of policies

The same economic data are subject to very different interpretations depending on who is looking at them. However, it is clear that the two logical policy choices are either no change or an increase of 1% or more.

The monetary policy committee has enough ammunition to justify either decision. A small increase does not make sense given that interest rates are already at very high levels and the gap with inflation is significant.

The direction of the SBP will depend on political ramifications, recent biases and reactions from international creditors.

The author is an economist and portfolio manager who has worked in Pakistan’s financial markets for a decade.

Published in The Express Tribune, August 22n/a2022.

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