Elixir Securities Limited – Elixir Insight

Karachi, February 01, 2019 (PPI-OT): Pakistan Economy – Monetary Policy Tightening Continues

SBP announced its monetary policy yesterday where it decided to raise PR/DR by 25bps to 10.25%/10.75% against our and consensus expectation of status quo.

SBP reasoned the need to continue monetary tightening as part of consolidation measures aimed at reining in high Twin Deficits and inflationary pressures.

SBP’s Governor hinted at possible further rate hikes, however we believe there is no need of it due to relatively higher real interest rates, expected slowdown in GDP growth, and improvement in Twin Deficits.

SBP Raises Interest Rate by 25bps: SBP unveiled its monetary policy through press conference yesterday where it decided to raise Policy Rate (PR) / Discount Rate (DR) by 25bps to 10.25%/10.75%. This was against our and consensus expectation of status quo. Expectation of status quo was premised upon slowdown in inflation, Current Account Deficit (CAD) and Large Scale Manufacturing (LSM) growth. SBP also accounted the following in determining its course of action viz. 1) moderation in headline inflation during the last couple of months as it came down to 6.2%YoY in Dec-18 from 6.8%YoY in Oct-18, 2) narrowing down CAD though gradually declining by 4.4%YoY, and 3) contraction in LSM growth by 0.9%YoY during 5MFY19.

A Case of Monetary Policy Tightening: SBP has cumulatively increased Policy Rate by 450bps over the last 12 months to rein in inflation and high Twin Deficits. We did not foresee need of further rate hike in recent monetary policy (and even going forward) due to slowdown in inflation, CAD and LSM, however SBP was likely looking through a different lens. In the recent primary auction of Pakistan Investment Bonds, cut-off yield remained flat compared with that in preceding auction as the government accepted bids worth PKR47.1bn (16.4%) out of total bids of 287.7bn making us believe that the government and in turn SBP would likely be convinced of plateauing interest rates; however, this was clearly not the case as the banks appetite substantiated the case for SBP to further raise policy rate. This was somewhat corroborated by the SBP’s governor in press conference and it was also noted in monetary policy statement that marked shift in the pattern of government borrowing from banks to SBP entailed risk of growing inflationary pressures.

Inflationary Expectations Largely Unchanged: While headline inflation slowed down, the core Non-Food Non-Energy (NFNE) inflation remained sticky reaching 8.4%YoY in Dec-18. Latest Consumer Confidence Survey indicated slowdown in inflationary expectations as 43.2% respondents expected increase in inflation during Jan-19 compared with 47.2% during Nov-18. However, SBP noted that inflationary pressures arising from second round impact of PKR depreciation, hike in gas and electricity tariffs and higher government borrowing from SBP are expected to be offset by increase in policy rates and decline in international oil prices. Thus, it kept its inflation expectations unchanged at 6.5-7.5%.

Economic Growth Forecast Maintained at 4.0%YoY in FY19: SBP remained cognizant of economic slowdown where it maintained its expectation of GDP growth of 4.0%YoY in FY19. SBP noted that LSM contraction was attributable to moderation in domestic demand and sector specific challenges. The former was likely attributable to fiscal and monetary policies tightening. This together with decline in crop production from last year is expected to knock down services sector growth and overall economic growth.

Liquidity Driving Private Sector Credit: Private Sector Credit grew by 10.3% over 1HFY19 to PKR6.0tn compared with 6.3% growth over 1HFY18 to PKR4.7tn. Higher growth was led by liquidity arising from government’s retirement of borrowing from commercial banks, as well as due to rising cost of raw materials (particularly cotton and petroleum products) and expansion in construction-allied sectors (particularly in cement and steel sectors).

Budgetary Borrowing Jumps Massively: The government’s budgetary borrowing from SBP jumped massively by PKR3.8tn (108%) between 1st July 2018 and 18th January 2019 which was 4.3x the amount borrowed in the same period of last year. The budgetary borrowing were used to retire commercial banks’ debt of PKR3.0tn during this period. This shift was likely attributable to government’s shift to cheaper borrowings as the commercial banks likely demanded higher yields in the anticipation of rising interest rates. As such, M2 growth stood at 2.2% during this period compared with 1.1% during the same period last year.

1HFY19 Fiscal Deficit to Surpass Last Year Levels: SBP foresees Fiscal Deficit for 1HFY19 to surpass the level of last year. We believe that this is mainly attributable to rising debt servicing due to higher interest rates. Though higher interest rates are expected to increase fiscal deficit (by estimated PKR132bn for every 1% increase in interest rate where the governor stated a similar range of PKR100-150bn), SBP reiterated that fiscal policy needs to be proactive as it highlighted need for stability and sustainable growth. We believe that SBP implied the need of further fiscal consolidation measures in terms of curtailing expenditures mainly development expenditures (despite limited room in adjustment to debt servicing and defense expenditures), further rationalization in tariffs and duties and improvement in revenues through increasing tax base. We expect fiscal deficit to clock in at 6.2% of GDP in FY19 compared with 6.8% in FY18.

CAD Expected at USD13-14bn: CAD improved by 4.4%YoY to USD8.0bn in 1HFY19 which was driven by sharp deceleration in imports of goods and services. The impact of policy measures is visible as non-oil imports fell by 4.4%YoY in 1HFY19 compared with 19.1%YoY growth in 1HFY18. While exports remained flat, 10%YoY growth in remittances contributed in further improvement in CAD. Nonetheless, financing remained a challenge as private and official flows remained insufficient causing SBP’s reserves to plunge to USD8.2bn as of 25th January 2019. Pakistan is expected to receive USD2bn further loans from UAE to support its foreign exchange reserves. Besides, USD3bn deferred oil facility from Saudi Arabia is expected to further ease off external account pressures. The governor noted that CAD is expected to stand at USD13-14bn during FY19 and that the financing needs for the current fiscal year has been plugged.

Is It Not the End of Monetary Tightening?: SBP’s governor alluded that the interest rates have almost peaked out; and also made note of IMF’s importunities if and when Pakistan enters a fresh IMF program. We believe that further (even limited) monetary policy tightening is not required as the real interest rate over headline/core inflation is expected to average 2.8%/1.6% over 2019 (with no further interest rate hikes) compared with 7-year average of 2.4%/1.2%. The real interest rate differential with global economies mainly US is likely to remain at ease too with US Federal Reserve Bank holding off interest rates in its latest monetary policy and casting doubts on further hikes in interest rates. However, there is risk to our thesis that IMF will likely push for raising real interest rates above historical average to rein in Twin Deficits, which in our opinion is likely to have rather significantly negative effect at least on Fiscal Deficit as government’s reliance on debt remains relatively inelastic in short to medium term.