Monetary Policy Review: Cautious Optimism

100 basis point cut justfied!
A balanced and responsible policy statement was presented by the state bank governor on the 15th of August. The governor clearly stated the positives which have emerged in last six month but was quick to classify them as “nascent positives” and suggested that the economy requires structural reform for the sustainability of the positives. Amidst these positives the central bank decided to loosen its stance on monetary policy and reduces the benchmark discount rate by 100 basis points. The market consensus prior to the statement announcement was 150 to 200 basis point cut. Hence the central bank decision will not be taken as a positive development by the market, and we most likely will see a negative movement in the market in the current week. But a more circumspective view taken by the central bank will help the economy on the long run.
Good news on the Macro Economic front
The country has seen improvement in key macroeconomic indicators following continued implementation of the macroeconomic stabilization program. The CPI inflation continues to fall, the CPI has shown about 7% drop in last three months. Government borrowing from the central bank remains within quarterly limits and the SBP's foreign exchange reserves have increased. These positives in turn, reflect contraction in aggregate demand, much-needed fiscal consolidation, and an improved balance of payments position. The gradual improvement in macro fundamentals has also stabilized the local money market and the PKR and USD exchange rate has remained within a tight range.
IMF targets Achieved
The SBP met successfully, the three main end-June IMF performance criteria. Both the stock of budgetary borrowings from the SBP at Rs 1130 billion and Net Domestic Assets (NDA) of SBP at Rs 1183 billion were below their respective target ceilings of Rs 1181 billion and Rs 1321 billion. Similarly the Net Foreign Assets (NFA) of SBP at $3.98 billion was higher than the targeted floor of $2.37 billion.
Security issues and Electricity shortage: are bringing the economy to halt
Due to electricity shortages and security issues, real GDP growth has fallen to 2.0 percent in FY09, down from 4.1 percent a year earlier. Large-scale manufacturing activity has already seen a record run of 11 consecutive months decline up to May 2009. Furthermore, there has been no growth in credit to the private sector.
Implementation of new interest rate corridor system
The SBP has announced the implementation of new interest rate corridor system that will replace repo market. This was one of the requirement placed by IMF, the hope is that it will help reduce volatility in short term interest rates and bring more transparency in the implementation of monetary policy. The corridor will operate through standing overnight repo and reverse repo facilities, that is, floor and ceiling. The interest rate corridor will consist of two end-of-day standing facilities. Existing three day repo facility would be renamed as SBP overnight reverse repo facility, which would become the ‘ceiling’ and a new SBP overnight facility which absorbs excess funds from the market would serve as ‘floor’ of the corridor. The minimum amount for the overnight repo/reverse repo facility will be Rs 100 million and in multiples of Rs 50million. The newly introduced SBP overnight repo facility will be available at 10% per annum. This will serve as the ‘floor’ for the interest rate corridor. Hence, the floor and ceiling levels for the interest rate corridor are 10% and 13% per annum respectively with the width of 300bps.
MPC and increase in frequency to bring transparency
The SBP also constitutes the independent monetary policy committee (MPC) that will have external experts as members in addition to the SBP and the SBP Board representatives. The inclusion of external members is aimed to ensure that the SBP benefits from expertise and independent views concerning monetary policy and this step will bring in line with best international practices by enhancing the transparency and credibility of monetary policy formulation process. The central bank has also decided to increase the frequency of monetary policy decisions from four to six times in a year.
What’s in it for the market?
Unfortunately the policy statement will not jell well with the market participants in near term. As pointed out earlier the consensus in the market was that the central bank will go for a harder slashing on the discount rate and will cut it by 200 basis points. The bankers were also anticipating a bigger cut in discount rate as reflected in the KIBOR rates. However it is obvious that the central had to take a circumspective view and provide a balanced statement. We would expect 4 to 5% reduction in the index from current point before it consolidates again.