We expect the MPC to be proactive and upwardly adjust the policy rate in coming months to curtail the growing current account (CA) deficit. It was demonstrated on Sep. 20 when the rate-setting panel increased the rate by 25bps to 7.25%. Although the State Bank of Pakistan (SBP) retained its CA deficit forecast at 2-3% of GDP in FY22, there are apprehensions that deficit could breach this projection. In the first two months (Jul-Aug) of this fiscal year, the CA deficit stood at USD 2.3bn or 4.1% of GDP, primarily owing to sharp pick-up in imports as economic recovery gained traction. One of the reasons, in our view, for keeping the CA deficit forecast unchanged could be that the SBP might be hopeful that the recent exchange rate depreciation as well as tightening of regulations for consumer financing might subdue the imports growth.
Since the MPC considers the current monetary policy stance to be appropriately supportive of growth and sees real interest rate to remain negative in near term (we assume it means the next six months), we believe that the policy rate could be hiked at most by 75bps till April 2022. However, one thing seems to be certain - there will be upward adjustment in policy rate, but it would be measured and gradual. This would be a clear departure from the past; for instance, the interest rate was raised by 675bps in a short span of one year between July 2018 and July 2019. At the time, the country was facing a balance of payments crisis. Despite the surge in CA deficit, there is no such crisis in the making as the SBP's forex reserves stood at record USD 20.1bn at August-end compared to USD 7.3bn at June-end 2019.
The rise in CA deficit is also putting pressure on the exchange rate as the Pakistani Rupee (PKR) weakened by about 11% against the USD since mid-May. Although the SBP has adopted a flexible market-based exchange rate regime, there have been speculations that the central bank heavily intervened in the forex market to stabilize the PKR. The SBP in its latest policy review neither confirmed nor denied it. "Over the last few months, the burden of adjusting to the rising current account deficit had fallen primarily on the exchange rate and it was appropriate for other adjustment tools, including interest rates, to also play their due role," the MPC noted as it provided another rationale for the latest policy rate hike.
Moreover, the MPC revised upward its GDP growth forecast for this fiscal year as it noted that the pace of the economic recovery has exceeded expectations since its last meeting in July. "Growth in FY22 is now expected toward the upper end of the forecast range of 4-5% [y/y]," the MPC said, adding strong imports as well as tax collections are reflective of acceleration in growth.
On price front, the rate-setting panel appeared mildly concerned over the inflation trajectory. Although the CPI inflation eased to a seven-month low of 8.4% y/y in August, the MPC said that inflationary pressures could emerge later in this fiscal year due to rising demand pressures and higher imported inflation - mainly due to depreciation of the PKR. During Jul-Aug FY22, retail inflation stood at 8.4% y/y, which is well within the MPC's projected range of 7-9% y/y in this fiscal year.