KARACHI: The State Bank of Pakistan (SBP) on Tuesday stressed urgent need to initiate structural reform in the economy.
“Setting the direction and pace of the reforms is important not just to address the recurring macroeconomic imbalances, but also to push the economy’s productivity frontier,” the central bank said in its report on the State of Pakistan’s Economy – First Quarter for Fiscal Year 2018/2019.
The SBP said that the overall macroeconomic environment remained challenging during the first quarter of FY19.
The foremost concern was the steep rise in global crude prices, which not only reinforced the already strong underlying inflationary pressures in the economy, but also eclipsed emerging improvements in the external sector.
Moreover, uncertainties lingered with regard to the needed balance of payments (BoP) support on account of a political transition underway.
Fiscal pressures also remained intact as expenditure rigidities allowed only a limited room for the government to maneuver.
Responding to these challenges, the new political regime immediately announced cuts in development spending, partially reversed tax relief measures, and also explored avenues to bridge the external financing gap.
In effect, this can help preserve growth, particularly at the juncture where the economy has begun to lose momentum
In fact, large-scale manufacturing (LSM) contracted for the first time in over 7 years during Q1-FY19.
The broad-based nature of this contraction suggested that the impact of exchange rate depreciation and stabilization measures (including a sharp cut in PSDP spending, increase in interest rates, and the imposition of regulatory duties) had begun to materialize.
Furthermore, important budgetary measures such as the imposition of a ban on property and car purchases by non-filers restricted the activity in these sectors.
The agriculture sector also under-performed, as lower-than-average rainfall in the country aggravated the prevailing water shortages.
Resultantly, kharif crops were cultivated over a lesser area compared to last year, leading to a decline in crop harvests.
Notwithstanding the slowdown in economic activities, SBP shored up its stabilization efforts and tightened the monetary policy further during the quarter.
In each of the two policy decisions that were held during the quarter, the Monetary Policy Committee increased the policy rate by 100 basis points.
These decisions were guided primarily by the prevalence of high twin deficits as well as the increased likelihood of headline inflation surpassing the annual target of 6 percent.
While demand pressures remained strong, core inflation continued to trend upwards also as the second-round impact of higher fuel prices and exchange rate depreciation began to seep into the broader economy.
The increased raw-material prices and capital outlay also meant that the credit appetite of the private sector was strong, despite a slowdown in the overall economic activity.
The impact of input prices (especially cotton and crude oil) on the overall credit off-take can also be seen from the near doubling of average loan size in Q1-FY19 compared to the same period last year.
This implies that a substantial part of the higher off-take during the quarter was price driven.
From banks’ perspective, the price effect was a favorable development, since it led them to temporarily readjust their asset portfolios away from government papers in anticipation of further interest rate hikes.
This development can be attributed to the government’s consistent rejection of high-rate bids in primary auctions, contrary to market expectations of inflation trajectory and interest rates.
The behavioral interplay between banks and the government continued to complicate debt and monetary management.
From the debt management’s perspective, the consistent shortening of the maturity profile raised refinancing and rollover risks for the government; and from the monetary management’s perspective, the near-flattening of the yield curve and excessive government borrowings from SBP posed major challenges.
The absence of longterm benchmark rates amid excess liquidity in the interbank market (due to heavy retirements by the government) did not allow a complete transmission of changes in the monetary policy to the retail lending rates.
From the government’s standpoint, avoiding an increased mark-up was intended to contain the overall fiscal deficit, especially at a time when the stock of public debt had reached a record high.
Importantly, interest payments (debt servicing) were already the single-largest expense incurred by the government in FY18, eating up 33.6 percent of the country’s tax revenues.
In Q1-FY19, these payments were 13.9 percent higher compared to the same period last year.
Although other expenditures remained subdued, especially PSDP that dropped by 45.5 percent over last year, the fiscal deficit stayed at a high level.
This was mainly because revenue collection could not keep pace with growing current expenditures.
Thus, the overall fiscal deficit reached Rs 541.7 billion in Q1-FY19 – almost Rs 100 billion higher than in Q1-FY18.
Unlike the past few years, the bulk of the financing burden did not fall on the domestic banking system as domestic non-bank sources provided sufficient funding to the government.
External funding was also available that made up for 38.9 percent of the total fiscal deficit.
Importantly, the latter also supported the country’s external sector.
The overall current account deficit declined slightly for the first time in over two years, but stayed at an elevated level in Q1-FY19.
The persistence of a large deficit owed primarily to the worsening terms of trade: while export growth slowed down from 12.4 percent last year to only 3.8 percent in Q1-FY19, a sharp increase of 50.9 percent in global crude prices pushed up the import bill.
In fact, the increase in oil payments was large enough to offset a combined gain from a decline in non-energy imports, exports growth, and a healthy increase in workers’ remittances.
With FDI falling 42.6 percent YoY, official borrowings played an important role in plugging the gap.
Still, the reserves drawdown continued, and the level at end September 2018 was not sufficient to cover 2 months of the country’s import bill.
In this context, although the economy is responding to stabilization measures taken over the past few months, the persistence of near-term challenges to the economy (low FX reserves and rising inflation) does not allow for any policy complacency to set in.
Importantly, the domestic demand has witnessed moderation during Q1-FY19 relative to last year, but compared to recent averages, major indicators still reflect vibrancy.
As mentioned earlier, the disaggregated analysis of core inflation also suggests contribution from both demand- and supply-side factors.
Therefore, it appears that the country would continue to move along the macroeconomic adjustment path for some time.
However, in order to revert to a stable macroeconomic environment, it is equally important to address the policy uncertainties and spell out a clear path of economic reforms going forward.
The most immediate requirement is to secure frontloaded BoP support that can lift some pressure from FX reserves as well as the Pak rupee.
The confidence of consumers and businesses alike, which had improved sharply soon after the elections, seems to have tailed off in the most recent surveys on account of rising cost pressures and an uncertain outlook.
Furthermore, since the new government has hinted at major revisions in investment and industrial policies, investors (especially foreign investors) seem reluctant to take long-term positions.
These developments run the risk of intensifying the impact of stabilization measures on broad economic activity.
However, it is important to note that the government has initiated important reforms in the fiscal sector that can later be built upon to alleviate the structural deficit.
For instance, policymaking power has been taken from the FBR, to be shifted to an independent authority.
The FBR will be focusing solely on tax administration and collection. Furthermore, efforts are underway to ensure access to third-party data to have information on potential high net-worth individuals.
Moreover, taking an initial step towards reforming the real estate sector, the government has notified the establishment of the Directorate General of Immovable Properties, with the mandate ranging from conducting survey-based market valuations, to establishing linkages with provincial revenue & excise authorities.
This is a major initiative, which along with the increased inter-provincial co-ordination, can potentially help reduce prevailing distortions in the economy’s incentive structure and also improve revenue collection.
With regards to the energy sector, the government has approved an upward revision in gas prices in order to alleviate the financial burden of gas distribution firms.
In sum, while efforts are underway to regain macroeconomic stability, the concurrent progress towards reforms is welcome.
It is now important to deepen and accelerate the pace of reforms within the fiscal and energy sectors, and also spread the process across other sectors of the economy.
The objective should be to rationalize the economy’s incentive structure; enhance ease of doing business via embracing technology and simplifying procedures; and improve public financial management and governance.
Putting right policies in place is critical, even if it takes time, to get the economy out of the boom and bust cycle. This is important also to benefit on the productivity front, in order to push the growth momentum forward.
At this point, when the country’s growing labor force has to be productively engaged, the country cannot afford to get caught up again in a low growth-high inflation equilibrium.