Consumer inflation has barely retreated from a 17-month high of 15.7 per cent struck in September, despite the policy tightening. — File Photo

KARACHI: Pakistan’s central bank is expected by most analysts to raise its policy rate by 50 basis points to 14.5 per cent on Saturday, which would be its fourth consecutive increase for the fiscal year ending in June 2011.

Consumer inflation, in double digits for more than a year, has barely retreated from a 17-month high of 15.7 per cent struck in September, despite the policy tightening.

Here are some questions and answers about the country’s inflation and policy responses:

What are the market expectations?

A Reuter’s poll found 8 out of 10 analysts expect the central bank to increase its key policy rate by at least 50 basis points to 14.5 percent because of high government borrowing following delays in tax reforms, lack of foreign inflows and higher international commodity prices.

Analysts said the central bank was unlikely to loosen its monetary policy in the coming months, although how far it would tighten depended on whether it received international funding and on global commodity prices.

How serious a threat is inflation?

Annual inflation in December rose to 15.46 per cent even though the monthly pace of price rises fell to 0.51 percent and is likely to fall further due to the base effect. The biggest rises over the past few months have been food prices.

The government has further aggravated the problem through its heavy borrowings from the central bank, which the State Bank of Pakistan subsequently funds by printing money.

Real interest rates are still marginally negative but analysts said that could change as January’s inflation is expected to be lower due to the base effect.

How does government borrowing matter?

Because of the vicious cycle the heavy borrowing spawns. The government has been unable to broaden its tax-to-GDP ratio, currently around 10 per cent and one of the lowest in the world. It eliminated food and fuel subsidies, but still has subsidies on electricity which it is unable to eliminate because of political pressure.

The International Monetary Fund (IMF) has asked Pakistan to implement a reformed general sales tax, another measure to broaden its tax base, before it can release the sixth tranche of an $11 billion loan programme that the country turned to in November 2008.

This month, the government also reversed its decision to increase local fuel prices due to political pressure, which is going to cut into its revenue. If local fuel prices are kept unchanged and international oil prices keep rising, then the government would eventually have to subsidise fuel and borrow more money from the central bank.

The government has borrowed nearly 120 billion rupees ($1.39 billion) from the central bank from July 1 to Jan. 15, compared with the same period of the previous year when it was a net creditor. This increases money supply and fuels inflation.

Government borrowing from commercial banks has also increased substantially to around 217.5 billion rupees ($2.53 billion) from July 1 to Jan. 15, 27 per cent higher than in the same period last year.

Without any rise in the government’s revenue, analysts expect the 2010/11 budget deficit is likely to be more than 7 per cent of GDP, compared with a target of 4.5 per cent agreed with the IMF. The budget deficit for six months ending Dec. 31 was 3 per cent of GDP.

What can the central bank do?

According to some analysts, the previous three consecutive rate rises sought to discourage government borrowing, but they proved ineffective in weaning Islamabad off the central bank.

Given the futility of further policy tightening, analysts reckon the State Bank of Pakistan would rather give priority to economic growth by keeping the key policy rate unchanged. The balance of payments position is favourable and the current account posted a surplus of $26 million for the July-December period. The sluggishness of the manufacturing sector, which indicates a lack of private sector demand, has also given the State Bank a reason to lean towards a looser policy stance.

Large scale manufacturing (LSM) fell 2.3 per cent in July-November of fiscal year 2010/11 from a year ago.

What other tools do the bank and government have?

The SBP has been encouraging remittances from overseas Pakistanis, a move which has slowed the pace at which the rupee was falling and helped improve the current account gap. The rupee weakened by 22 per cent against the dollar in 2008, a further 6 per cent in 2009 and only 1.53 per cent in 2010.

Export growth has been robust and, along with a rise in remittances, has contributed to a surplus in the current account balance.

Besides raising rates, the SBP could raise statutory reserves for banks, but it appears loath to do so because of the burden government borrowing is placing on the banking system, causing yields to rise. Six-month bill yields are above 13 per cent.