SBP first quarterly report for FY08
Sunday, January 06, 2008
KARACHI: The State Bank of Pakistan in its first quarterly report for financial year 2008 has said that risks to the economy are increasing due to global and local uncertainties while political clamour ahead of upcoming elections is affecting investor sentiments. Following is the text of the overview.
Pakistans economy performed reasonably well in the initial months of FY08, coping with the increased uncertainties in the domestic and international economic environment.
Nonetheless, risks to the economy are increasing, as it is clear that neither the global nor the domestic economic environment is as benign as in past years.
The somewhat. While the domestic economy seemed relatively unscathed, like rest of the Asia, from the turmoil in the international capital markets, the global impact of the subprime mortgage crisis is still unfolding.
Pakistan has had substantial success in managing its large external account imbalances in recent years, but these imbalances have grown in FY08, increasing the risk that the country could be impacted adversely, particularly if the domestic demand pressures grow in forthcoming months and if problems in the international credit markets worsen.
The threat of renewed macroeconomic complications, after five years of good performance, would be further heightened if prompt actions were not undertaken to correct the recent deterioration in fiscal indicators.
The fiscal imbalance has already led to a substantial rise in government borrowings from the central bank, which rose to Rs191.3 billion during July-December 1 FY08, exceeding both quarterly and annual ceilings and preceding years trend. This has enhanced monetary expansion significantly and is likely to fuel inflationary pressures, compounding the impact of the strength in international commodity prices.
The FY08 growth is also likely to be below the 7.2 percent annual target.
The FY08 kharif harvest was hurt by the damage suffered by the cotton and rice crop due to floods and pest attacks.
While the overall agri-growth target may yet be achievable, this would however require that the impact of the record sugarcane harvest be complemented by an exceptional showing of the rabi crops (especially by a substantially above-target wheat harvest) as well as a robust performance by the livestock sub-sector.
The aggregate growth of large-scale manufacturing (LSM) has decelerated in Q1- FY08 (see Table 1.1), although disaggregate data reveals a mixed picture.
Production growth in many industries including fertilizer, pharmaceuticals, petroleum refining and few metal and engineering goods have rebounded strongly in FY08 after disappointing performances in the previous year.
In contrast, the first quarter outcome of a larger number of industries reflects slower growth, often due to industry-specific circumstances.
This is most evident in the cotton yarn and cloth (that suffered due to weak exports demand and a poor cotton crop), automobiles (the government relaxed imports), and edible oil & vegetable ghee (demand slackened in the face of nearly doubled prices).
The outlook for the services sector, which accounts for over half of value-added in the economy, remains positive.
Acceleration in the retail & wholesale trade (with imports rising), higher profitability of the financial sector, and the robust growth in community services (helped by election-related activities) is expected to lead to strong growth for the sixth successive year. In short, it appears that despite the likelihood of some deceleration, the FY08 growth outcome is likely to remain reasonable (see Table 1.2).
Strength in aggregate demand, compounded by the considerable impact of rising global commodity prices is also reflected in the persistence of high domestic inflation.
The monetary tightening followed throughout FY07 and FY08 was successful in significantly reducing non-food inflation in Pakistan, but its pass through on headline CPI inflation was offset, particularly in the latter year, by the impact of the sustained increases in global food and energy commodity prices.
Consumer price index (CPI) inflation rose to 9.3 percent YoY in October 2007 principally driven by a 14.7 percent YoY jump in CPI food inflation.
A part of this jump reversed in November 2007, with overall CPI inflation coming down to 8.7 percent, as food inflation reported to be 12.7 percent, but even this is very high.
Food inflation is often volatile and short-lived, depending on crop cycles, etc.
For example, just four items (wheat, rice, edible oil and milk) contributed around 75 percent of the domestic food inflation during November 2007.
Of these, the direct and indirect impacts of increased demand for bio-fuels are more evident in the prices of edible oil, and dairy products. Here there is less likelihood of relief, in the short-term, unless energy prices decline sharply.
On the other hand, poor crops in major producing countries led to a surge in the international prices of rice and wheat, and the price of these may ease somewhat if global production recovers. More troubling is the fact that the high and volatile food inflation is now increasingly influencing core inflation as well.
Since May 2007 both measures of core inflation (i.e. non-food non-energy and the 20 percent trimmed mean) have been trending up.
In other words, after resisting throughout FY07, the prices of a broader range of the CPI basket is now being impacted by the cost push of high commodity prices, as suppliers of goods and services raised prices to protect their margins.
These inflationary pressures could rise further, if fiscal imperatives force the government to pass through the impact of the recent oil prices.
The risk of such a second round of inflationary spiral was highlighted in the Monetary Policy Statement issued in July 2007.
Since inflation in recent months had been driven substantially by supply-side factors such as food and energy prices, this has given rise to a debate over the need for monetary tightening.
However, the emergence of a widening inflationary spiral in Pakistan as a result of the high commodity prices suggests that a tight monetary stance remains appropriate.
Were it not for the monetary tightening that helped curb demand pressures, and kept core and headline inflation in check, inflationary trends would have been more significant in both FY07 and FY08.
Since a substantial part of the rise in food inflation is a global phenomenon, it tends to restrict the impact of available relief measures.
While government is providing relief by the provision of key staples at subsidized rates through utility stores, its options for broader relief are, in the short-term, limited and involve challenging trade-offs.
(1) Any substantial subsidies involve fiscal costs as well problems in ensuring that it goes only to the vulnerable. For example, traders have the incentive to purchase goods at subsidized rates for re-sale at market prices.
(2) Subsidies can also raise allocation inefficiencies. Inappropriate subsidies may destroy the economic incentives for producers, ensuring that shortages persist for years.
It should also be remembered that the domestic economy is now more open and prone to external shocks than ever before. This has important policy implications going forward. First, domestic prices will be more sensitive to the changes in international prices, despite domestic availability. For example, Pakistan has sufficient exportable surplus of rice in FY07, but following a rise in the international prices of rice, domestic prices also increased.
Second (and more important), the differences between farm gate and import prices have to be narrowed in order to provide incentives to farmers.
This is probably the only way to ensure sustainable productivity gains and smooth supply of agri-produce in the medium to long-run.
This would involve measures to enhance productivity, encouraging market competition, and increasing investment in food processing and storage, etc.
Macroeconomic sustainability during the course of an inflationary period is critical. After relatively subdued growth in the initial months of FY08, the growth of M2 has accelerated in November 2007 and onwards, pushing the Jul-1st Dec FY08 growth to 4.2 percent (almost unchanged from that in corresponding period of FY07).
This was led largely by government borrowing that offset the impact of a moderation in private sector growth.
The M2 growth still is manageable given that in the first 5 months, the net foreign assets flows grew slower than in the preceding year, and that reserve money growth during FY08 has been sharply lower than in the previous year.
The growth in the reserve money during Jul- 1st Dec FY08 has been only 6.3 percent, as compared to 11.8 percent in the corresponding period last year.
The recovery in the growth of private sector credit (net) September 2007 onwards indicates that aggregate demand remains reasonably strong, that there is substantial room for banks to lend (as credit-deposit ratio is low and the liquidity position of banks is eased by OMOs as and when required), and that some of the factors that temporarily depressed demand in FY07, are now abating.
Banks that had slowed credit activities due to merger and acquisition activity (such as Standard Chartered Bank and ABN Amro) are regaining momentum, and seasonal demand is picking up.
Moreover, there is the possibility that financing of long delayed power projects may also be seen in FY08. It is also likely that companies, which met their demand from external borrowings in earlier periods may revert to the domestic markets given the widening of spreads overseas.
All key fiscal performance indicators have deteriorated significantly in Q1-FY08 (see Table 1.3).
This is reflected in the higher recourse to the central bank borrowing in recent weeks (which is infusing pressure on core inflation) despite higher receipts from the National Savings Schemes and the Pakistan Investment Bonds.
The governments budgetary borrowings from the banking system during July- 1st Dec FY08 rose by Rs191.3 billion compared to Rs97.6 billion over the corresponding period in FY07.
Importantly, the revenue balance moved from a surplus in the first quarters of the preceding years to a deficit in Q1- FY08, despite an impressive growth of 22.3 percent in total revenues during Q1- FY08. The current trend indicates that the fiscal deficit target will not be met unless appropriate corrective measures are taken promptly.
Another challenge is the countrys large external current account deficit. Recent evidence indicates that the modest contraction seen in July-October, 2007 is unlikely to continue in months ahead.
The trade deficit remains high, although it did benefit from an export pick up (though growth remained below FY04-06 trends) and import compression.
While the continued growth in remittances by 22 percent was encouraging, its impact was diluted by continued service and income account deficits.
During July-October 2007, Pakistan recorded a surplus of $3.2 billion in the capital and financial account compared to $2.8 billion last year. Most of the surplus emerged from debt flows as the equity flows were impacted by $2.0 billion gross outflows in SCRA during Jul-Nov FY08 and postponement of new privatisation programs.
Given the commitments in the pipeline, momentum in foreign flows could pick up further in the last quarter, possibly supported also by the floatation of global deposit receipts.
However, notwithstanding the modest improvement in the initial months of FY08, the annual current account deficit remains large; current SBP forecasts indicated that the annual FY08 deficit could remain around 5.2 percent of GDP, very close to the levels seen in the previous fiscal year.
While the growth in exports during FY08 are expected to see a significant improvement over the weak growth in FY07, the gains are expected to be offset by a rising oil import bill (particularly if international oil prices remain high), and a jump in imports of machinery (particularly as power projects reach financial close).
SBP first quarterly report for FY08
