Given that the current account deficit is now likely to continue to shrink for the next several months, the month-on-month core inflation rate has fallen every month since May 2008, the fuel subsidies (the principal cause of deterioration in the fiscal position) have been withdrawn, and the manufacturing production is falling, the balance of risk in Pakistan’s economic outlook has shifted from inflation to growth.

Do the IMF and Pakistani officials, who are negotiating the package, understand this? Have they taken into account these recent developments and trends, and their policy implications?

Apparently not because there are indications that the IMF wants an increase of three percentage points in the central bank’s benchmark discount rate to 16 per cent as part of its bailout package for Pakistan. Would that be a right move at this time?

Superficially yes, if one compares it with Iceland which raised interest rates by six percentage points to get $2 billion from the IMF but Pakistan’s external debt to GDP ratio of 28 per cent is tiny compared to Iceland’s 545 per cent and much smaller than Ukraine’s 71 per cent.

In both the cases, most of the external debt comprises short-term borrowings by the private sector. In contrast, most of Pakistan’s external debt represents official long-term borrowings from foreign governments and the multilateral institutions. Therefore, Pakistan’s case is not comparable with either Iceland or Ukraine. How about inflation? Would that justify an interest rate hike? Probably! However, a careful analysis reveals a different picture.

On July 29, 2008, Dr Shamshad Akhtar, Governor State Bank of Pakistan increased the central bank’s policy rate by 100 basis points to 13 per cent stating the bank had decided to do so “considering the risk related to rising external current account and fiscal deficits and worsening inflation outlook to contain further aggregate demand pressures which are contributing to the inflationary pressures”.

Since July, the international as well as Pakistan’s economic scenario has dramatically changed. The balance of risk has shifted from inflation to slower economic growth and liquidity crunch. The global financial meltdown and a severe credit crunch in the United States and Europe have sparked fears of a deep and prolonged recession. In October, commodities had the biggest monthly drop since at least 1956 and Reuters/Jefferies CRB Index of 19 raw materials plunged 22 per cent on concern that a slump in global economic growth will sap demand for raw materials.

Inflationary pressures have eased not just in the developed world but through out Asia as well. China and India announced interest rate cut in October, and growth in both the countries is expected to slow down to the slowest pace in four years. South Korea, Taiwan, Indonesia, the Philippines and Thailand reported slower inflation during the first week of November, and the central banks in Australia, Hong Kong, Japan, South Korea, Taiwan and Vietnam have all announced rate cuts since the last week of October.

In Pakistan’s case, the economic growth could be 3.5 per cent or even lower during the current fiscal year. For the first two months of the current fiscal year, the large-scale manufacturing production index, including cotton yarn and cloth sectors, reported a drop of 6.46 per cent compared to the same period in the prior year.

The economic outlook for the next 12 months is clouded by the prospects of a slow down in growth as investment activity has visibly dropped and business confidence is low. Pakistan sends about 42 per cent of its exports to the United States and Western Europe. With both these regions facing recession, Pakistan’s mostly low-valued added exports and workers’ remittances could be at risk.

However, the current account deficit is likely to shrink sharply in the next 12 months. Over 60 per cent of last fiscal year’s $7 billion rise (over 100 per cent ) in the current account deficit was due to high oil and other commodity (notably edible oil, wheat, and fertiliser) prices, which have dropped by 40-60 per cent from their peak levels in 2008 and below the average import prices paid by Pakistan in 2007-08. Since July 29, the crude oil price has fallen by 47 per cent to $64 a barrel, palm oil’s by 48 per cent to about $437 a metric ton and wheat price by about 35 per cent to $192 a tonne.

Fuel subsidies constituted the largest contributor to the federal government’s ballooning fiscal deficit but have been almost completely eliminated. Still the net government sector borrowing from the monetary system grew by 5.3 per cent during the four months to October 30, or at annual rate of 17 per cent. This was due to the fact that the government did have substantial fiscal burden during the first quarter of July-September and it took time to phase out the subsidies.

However, the credit to the private sector has contracted in real terms since the beginning of the current fiscal year in July. The slump in the private sector activity was clearly evident in a nominal increase of just 0.8 per cent in overall lending to the private sector during this period.

At the same time, the interest costs have climbed sharply as illustrated in the graph for the three month Karachi inter-bank offer rate; a key benchmark for lending rates, which traded around 15.27 per cent on November 7. The actual lending rates to borrower are obviously higher.

The inflation is expected to come down as food, fuel and transportation account for 55 per cent of the consumer price index and contributed to even so-called non-food, non-energy inflation.

The latest data from the central bank confirms this view. As shown in the graph, the core (non-energy non-food) month-on-month inflation rate has declined every month since peaking in May 2008. Its refined version called the trimmed inflation - as it excludes abnormal or extreme movements to get a better picture of average trend- has shown a decelerating trend in the most recent months, as indicated by one per cent increase in September 2008 (over the previous month) compared to two per cent in August 2008 and 2.3 per cent in July 2008.

If the current monthly rate of core inflation stays at one per cent or lower, which is more likely, the expected core inflation rate for the next 12 months would not be more than 12.7 per cent. On this basis, the expected real borrowing rates are currently positive. That was not the case in January or July when the central bank increased the policy rate.

Following a sharp increase in the lending rates in the recent months, the average interest spread (the difference between average lending rate and the average cost of funding) has increased every month since June 2008, and was reported at 7.49 per cent in September 2009 compared to 6.78 per cent in June 2008. This is not a healthy trend and indicates that while the large banks are earning higher spreads, both the private sector borrowers as well as depositors have been the losers since the monetary tightening began.

Another worrisome development during this period has been that the central bank had to take unusual