KARACHI: The State Bank of Pakistan (SBP) hiked the key discount rate by half a percentage point on Friday, bringing it to 10.75 per cent, while warning that the economy faced continuing headwinds. The higher rate becomes effective from April 1.

The SBP also slashed its outlook on the growth rate for current fiscal year to 3.5pc. Only a week ago in its second quarterly report it had said growth could come in between 3.5 and 4pc.

The rate hike is likely to raise the cost of doing business as well as debt service payments for the government on domestic debt. It will, therefore, be a further drag on economic growth as well as the fiscal situation of the government.

Discount rate up to 10.75pc

The fiscal deficit, the difference between revenues and expenditures of the federal government, stood at 2.7pc of GDP in the first six months of the fiscal year compared to 2.3pc in the same period last year. The difference is notable because revenues, expenditures and GDP are measured in the trillions of rupees.

“In view of the shortfalls in revenue collections and escalating security-related expenditures it is most likely that the target for the fiscal deficit in FY19 would be breached,” a statement issued by the SBP said. It warned that since a large amount of the deficit was being financed via borrowing from the State Bank, which was tantamount to printing of money, the rate hike might not be effective in achieving its purpose of controlling inflation because further printing of money will “not only complicate the transmission of monetary policy but also dilute its impact and prolong the ongoing consolidation efforts”.

The central bank also warned of rising inflation, and persistent pressures on the external account despite the billions received in bilateral support since December 2018. “Amidst the efforts to curtail inflationary pressures and reduce the otherwise widening macroeconomic imbalances, domestic economic activity experienced the brunt of the stabilisation measures implemented thus far,” said the SBP. In particular, it added, large-scale manufacturing declined by 2.3pc during July-Jan FY19 against 7.2pc growth recorded in the same period last year.

The current account deficit remained high despite notable narrowing and continued to pose “significant challenge in terms of its financing”, the bank said. At $8.8bn in the first eight months of the fiscal year, the current account deficit is averaging more than a billion dollars a month. With exports flat, most of the narrowing had been achieved via import compression and higher remittances, the bank noted.

The year-on-year consumer price index (CPI) inflation has risen considerably to 7.2pc in January 2019 and further to 8.2pc in February 2019 — the highest Y-o-Y increase in inflation since June 2014.

“These pressures on headline inflation are explained by adjustments in the administered prices of electricity and gas, significant increase in perishable food prices, and the continued unfolding impact of exchange rate depreciation,” said the SBP.

“Core inflation rose for 13 months, accelerating to 8.8pc in February 2019 from 5.2pc a year earlier. Further, rising input costs on the back of higher energy prices and the lagged impact of exchange rate depreciation are likely to maintain upward pressure on inflation despite a moderation in aggregate demand due to a proactive monetary management,” said the SBP.

“As a result, headline CPI inflation is projected to fall in the range of 6.5 to 7.5pc for FY19.”

The State Bank said “a cut in development spending and deceleration in credit for fixed investments indicate a moderation in domestic demand.” In this backdrop, the real GDP growth is projected to be around 3.5pc in FY19.

The bank said that owing to stabilisation measures, the current account deficit narrowed to $8.8bn in July-Feb FY19 compared to a deficit of US$ 11.4bn during the same period last year - a fall of 22.6pc.

This includes a notable pace of retrenchment of the current account deficit by 59.9pc during the first two months of 2019 over the same period last year. This reduction in the external balance was mainly driven by a 29.7pc decline in the trade deficit in goods and services as well as a strong growth in remittances.

“Though still posing a significant challenge in term of its financing, the narrowing of the current account deficit has translated into some stability in the foreign exchange market,” the SBP observed.

It said the share of private financial flows needed to increase on sustainable basis to achieve medium-to-long term stability in the country’s external accounts.

“Much of the increase in credit demand was for working capital due to higher input prices and capacity expansions in the power and construction allied industries,” said the SBP.

The MPC noted that sustainable growth and overall macroeconomic stability required further policy measures as underlying inflationary pressures continued, the fiscal deficit was elevated and despite an improvement, the current account deficit was still high.

Published in Dawn, March 30th, 2019