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Presentation to Senate Committee on Finance, Revenue, Economic Affairs, and Statistics on“State of Pakistan Economy” By Dr. Shamshad Akhtar Governor State Bank of Pakistan
Macroeconomic outcome in FY08 • Inflation shot up to 21.5% in June 08 from 7% in June 07 (CPI YoY), further increasing to 25% in Oct 08. • Real GDP growth decelerated to 5.8% from 6.8% in FY07. • National savings declined to 13.3% GDP from 17.8% in FY07. • Investment declined to 21.6% GDP from 22.9% in FY07. • Fiscal deficit mounted to 7.4% GDP from 4.3% in FY07; Q1-FY09 deficit is 1% of GDP (annualized). • External current account deficit (CAD) widened to 8.4% GDP from 4.8% in FY07; July-Oct 08 deficit is 11.2% GDP (annualized). • Fiscal trends undermined monetary tightening on a regular basis. • FX reserves declined to $11.4 bln in June 08 from $15.6 bln in June 07; further depleting to $6.8 bln on November 25, 08. At the same time, Pak Rupee depreciated to Rs68.19 in June 08 from Rs60.32 in June 07; further depreciating to Rs78.71 on November 25, 08. 2
Key questions regarding FY08 outcome • Why inflation shot up so rapidly? When will inflation come down? • Why real GDP growth faltered? When will growth momentum be restored? • Why national savings declined so abruptly? When will savings start increasing? • Why investment rate declined? When will it start increasing? • Why fiscal deficit mounted so sharply? When will this become sustainable? • Why current account deficit (CAD) widened so quickly? When will CAD become sustainable? • Why FX reserves depleted so rapidly? And why PkRs depreciated speedily? How can it reserves be build and exchange rate stabilized? • Rationale for monetary tightening? • What measures SBP has taken for reducing inflation, promoting growth and maintaining financial sector stability? • Is banking system resilient and sound? 3
Why inflation shot up so rapidly? • History of inflation in Pakistan since 1970 depicts sharp swings marked by few episodes of sharp uptrend with only a short phase of price stability. • Domestic inflation has been fuelled by strong aggregate demand pressures because of • Higher than sustainable fiscal deficit --in absence of other sources of borrowings, the Government uses SBP borrowings as a financing item; • Widening of the CAD that has prompted sharp depreciation of Rupee and declining forex inflows • Rise in global commodity prices in particular oil and food prices • Rising per capita incomes and remittances • Supply side constraints • Inflation is expected to come down on year on year basis, but average inflation for the FY is estimated to be in the range of 20%. • Inflationary trends will settle as the global inflation has come down and Government has reiterated its commitment to achieve net zero borrowings from central bank. Historical trends Demand pressures Fiscal deficit International prices 4
Why real GDP growth faltered? When will growth momentum be restored? GDP growth moderated significantly mainly due to a weak performance by commodity producing sector. Fall in investment rate not only resulted in economic slowdown in FY08 but it may also cause further deceleration in growth in current year. In addition, structural weaknesses such as power shortages explain the falling real GDP growth rate. High and rising inflation have contributed towards low economic activity. Current high level of inflation is intolerable and is one of the major risks to future growth prospects. 5
Why national savings declined so abruptly in FY08? When will savings start increasing? • Private sector savings rate declined by 2.8%age points of GDP, mainly due to: • negative real rate of return on savings, including bank deposits, • acceleration in inflation, particularly food inflation, that squeezed surplus funds for savings. • Public sector dis-saved during the year; as percent of GDP its savings declined by 1.8%age points. • Positive real return on savings can incentivise people to save more. • Banks deposit to GDP ratio declined to 35.3% in FY08 from 36.9% in FY07 • Decline in fiscal deficit to sustainable level and low inflation can play an essential role in improving saving rate. Real return 7
Why investment rate declined in FY08? When will it start increasing? The entire decline was attributed to fall in private sector investment to GDP ratio by 1.3%age points; FDI to GDP ratio declined by 0.5%age points. Political uncertainty and unclear policy objectives during most of FY08; and worsening law and order conditions played a major role. Also, rising inflation, widening macroeconomic imbalances, downgrading in credit rating of the country, falling reserves and pressures on rupee parity made foreign investment unattractive. Macroeconomic stability with clear long-term policies and their objectives and improvement in law and order conditions is essential to raise investment in the country. 8
Why fiscal deficit mounted so sharply in FY08? Expenditures on subsidies surged to 3.8% of GDP (Rs395 bln) from 0.9% in FY07 (Rs76 bln). Interest expenditures increased to 4.7% of GDP (Rs490 bln) from 4.2% (Rs369 bln) in FY07. Non-interest expenditures shot up to 17.1% of GDP from 15.0%. Tax revenue stagnated to around 10% of GDP. Total revenue declined to 14.3% of GDP from 14.9% in FY07. 10
Why CAD widened so quickly and when will CAD become sustainable? CAD in FY08 reached an all time high of US$ 14.0 billion- more than double of US$ 6.8 billion recorded in FY07. In terms of GDP, CAD reached 8.4 percent compared to 4.8 percent last year. Jul-Oct FY09 data shows continuation of deteriorating trend in the external accounts - Jul-Oct FY09 CAD is up almost 100 percent compared to same period last year.
Why CAD widened so quickly ? • Surge in the international commodity prices: In FY08, 70% of rise in import value reflects the impact of imported inflation and oil price alone account for 45% of this increase. Notably, oil bill was equivalent to 80% of CAD and 2.1% of GDP. • Food imports were close to $3.5 billion – original BOP projection limited food imports, shortfall in domestic production called for imports. • Import demand pressures stoked by fiscal stimulus. • Portfolio flows declined sharply and illustrated their expected volatility. • Services account deficit rose due to increase in freight and insurance charges. • FDI of previous years led to increase in repatriation of profits and dividends. • Logistic support to US troops was half the FY07 level. • External assistance from donors was less than expected. Note: Sustained rise in remittances -- increase by 17 % FDI was close to $5 billion, and 36.4 % rise in non-textile exports.
For sustainability of CAD aside from narrowing trade deficit, strengthening of financial account would be critical CAD has for sometime breached sustainability limits but the risks was mitigated by a favorable external environment and improvements in Pakistan’s raised sovereign rating which made external financing cheap and easy. In FY08 country’s ability to tap the international capital markets was impaired – privatization deals and sovereign debt had to be deferred and portfolio investment plunged Jul-Oct FY09 external CAD at US$ 5.1 bln is exceptionally high.
Impact on FX Reserves & Exchange Rate Combination of developments discussed in previous slide resulted in significant rise in dollar outflows to finance CAD, while the inflows have declined as the financial account surplus fell. In the absence of matching inflows, deficit had to be financed though short-term borrowings and drawdown in reserves accumulated over past few years. Fall in country’s reserves along with deterioration of macroeconomic indicators, political instability and speculative activity in the forex market resulted in sharp depreciation of the rupee.
Foreign Exchange Reserves Total foreign exchange reserves of the country declined to $11.3 billion by end-Jun08 from $15.6 billion at end-June 07. As a result, import coverage ratio declined to 16.8 weeks in Jun FY08 from 30.7 weeks in July FY07. During July-October FY09, the reserves position further deteriorated, reaching $6.8 billion and import coverage declining to mere 9.2 weeks. However, with inflow of $3.1 bln from the IMF, reserves climbed back to US$ 9.4 billion by 26th November 2008.
Exchange Rate Pak rupee remained fairly stable up to October 07 in FY08, but in the following months, PKRs lost significant value against US dollar depreciating by 11.5 percent during Jul-Jun FY08. The depreciating trend continued in FY09, with Pak rupee depreciating further by 16.3 percent during Jul-Oct FY09. The loss in the value of rupee is attributable to a combination of rise in the CAD, fall in the financial inflows, increase in political noise and speculative activities in the FX market. With adjustment in interest rates and other policy measures, since end Oct-2008 upto Nov 25 rupee had appreciated by 3.6 percent, thus Jul- 20 Nov depreciation stands at 13.4 percent.
Rationale for Monetary tightening? 1.Unabated rise in inflationary pressures – in particular core inflation which rose to 18.3% in October 2008
2. Monetary tightening is pursued as high inflation is detrimental to economic growth
3.High budget recourse to SBP borrowings which are inflationary as evident from trends in core inflation
Pakistan Monetary Tightening stance because of country’s exceptional macroeconomic imbalances & resultant inflation International Comparison – Key macroeconomic indicators
Real interest are low in Pakistan compared with many other regional countries
Further monetary tightening was inevitable • Effective November 13, 2008, SBP raised its policy rate by 200 bps to 15 percent. • This increase in policy rate was necessary to: • ease demand pressures causing inflation • ensure long-term growth on sustainable basis; high inflation, if continues, raise future cost of production significantly more than the current rise in interest rate. • create room for government to borrow from market sources • Improve rate of return on savings • control inflationary expectations and stem second round effect of inflation • check depletion of forex reserve and depreciation of exchange rate • Even after this 200 bps increase in policy rate, current real interest rates are negative. • Credit to private sector private sector remained strong. Share of financial cost Inflation & Real rates CPS 32
SBP measures to promote growth • Measures for agriculture sector • Agriculture credit disbursement indicative target for FY09 has been enhanced by 25% to Rs 250 billion, which is 18.0% higher than disbursement in FY08. • SBP developed/launched Crop Loan Insurance Scheme- Under the scheme the government has agreed to share premium cost of subsistence farmers. • The State Bank has enhanced the indicative per acre credit limit for major and minor crops, livestock, orchards, fishing and forestry by an average 70 percent • Measures for Export and Industrial Investment • To promote real investment in the country and to mitigate the impact of higher interest rate SBP has restored 100 % refinancing under EFS and LTFF • Overall quantum of limits for banks under EFS for FY09 has been enhanced by 25% of the amount outstanding as on 30th June 2008. • Under these Schemes borrower have to pay max of 7.5 % mark-up against 14.4 % prevailing rate (weighted average) 33
SBP measures to maintain financial sector stability SBP provided on a timely basis over Rs350 billion liquidity support besides the regular injection of liquidity thru open market operations -- liquidity constraints emerged as a result of excessive public sector borrowings, deposit withdrawal and eid cash withdrawal. SBP launched liquidity support for small banks which provides maximum 3 months liquidity for small banks willing to restructure/inject new capital. This facility is available at SBP policy discount plus 3% and is supported by Government guarantee. To encourage more sustainable growth in deposit mobilization, SBP impose minimum deposit rate and exempted long tenor deposits from reserve ratios. Steps to stabilize and curb excessive volatility in foreign exchange markets. 34
Despite high economic stress banking system and its policies were sound? • Banking System is well capitalized: CAR at 12.1% is well above the minimum threshold • Asset quality is good: NPLs to loan ratio increased slightly during CY07 & 9M-CY08, at 8.4% by the end of September 2008 • NPLs to loans ratio (net) is at 1.9% as of end September 2008 • Provisions to NPLs ratio is 79.1% for H1-CY08: banks have already catered for any potential losses • Some liquidity issues emerged in recent past • Excess liquidity held by the banking system witnessed visible decline since May 2008 • Trends in O/N rates indicate temporary liquidity strains, more so for some small banks. The situation has improved with quick implementation of SBP policy actions. • Risk absorption capacity of the banking system remained strong CAR Net NPLs ratio Liquidity indicators Profitability 35
Key policy actions for restoring macroeconomic stability and sustaining growth… • Aggressive implementation of anti-inflation policies are needed to provide relief to masses and to restore investors confidence. • Fiscal sustainability is a key factor for macroeconomic stability, which requires: increase in tax-to-GDP ratio; containment in non-productive expenditures; public-private partnership • Increasing exports through diversification of products and markets and increasing productivity • Import compression through curtailing aggregate demand; not insulating domestic consumption from the impact of rising international prices • Financing has to be secured for the CAD which requires: • Increase in domestic savings to reduce reliance on external financing • Restoration of investor’s confidence to encourage investment inflows and restrict outflows • Consistency and continuation of prudent policies • To curb budget recourse to SBP financing there is need to now legislate strict limits on central borrowings and to launch a program to phase out the outstanding stock of central bank borrowing.
Link slides 37
CPI YoY inflation Back 12 ma inflation 38
Widening fiscal deficit to unsustainable level contributed in fueling aggregate demand Back 40
Surge in international oil and food prices also contributed to domestic inflation Back 41
Current level of major nominal and real interest rates Almost with all inflation measures, key real interest rates are negative Regional Comparison Back 43
Credit to private sector remained strong • During July 1- November 15, FY09 credit to private sector increased by Rs137 bln against Rs87 bln in the corresponding period of FY08. • Manufacturing sector received Rs77 bln credit during July-October FY09 against only Rs6 bln in the same period of FY08. • This increase in CPS was despite Rs255 billion decline in banks’ deposits. Back 45
Capital adequacy ratio Back 46
Asset quality indicator Back 47
Liquidity risk Back Excess liquidity 48