Outlook for exchange rate remains precarious

KARACHI: The calendar year 2012 depicted a mixed picture of the domestic financial markets. The money and forex market remained under stress due to the stagnating economy, which further drowned into soaring fiscal deficit and strained external account, but the equity market witnessed a positive trend during the year, said analysts.

Despite a long-delayed disbursement of $1.1 billion from the United States under the head of the Coalition Support Fund (CSF) in August, the money market’s liquidity showed stress as the central bank continued to inject substantial amount of liquidity in the banking system with a view to financing fiscal deficit and ease pressure on the external current account, they said.

Similarly, adverse developments in the current account made the forex market more volatile and pushed the local currency in a chaos-like situation. The rupee-dollar exchange rate depreciated by 7.8 percent, while the import coverage ratio dropped as foreign exchange reserves started depleting sharply in the second half.

A quick review of the money market performance reveals that unpredictable and persistent government borrowing created significant challenges for the monetary management. The market liquidity conditions remained captive to the government borrowing behaviour. Liquidity pressures in the money market further exacerbated in the last quarter of 2012 when it was led by weak official and private financial inflows, the pressure was put on domestic borrowing, said analysts.

The State Bank of Pakistan (SBP) in its latest monetary statement reported a year-on-year growth of 26.4 percent, which it attributed to the fiscal borrowing from the banking system, which helped in monetary expansion.

The central bank increased liquidity through substantial open market operations (OMOs). During July 1 to November 30, 2012, the government borrowed Rs586 billion from scheduled banks and retired Rs106 billion to the SBP. Consequently, the outstanding liquidity injections by the SBP stood at Rs615 billion as on December 14.

The central bank maintains the view that the size of these injections would not be a source of concern as inflation stays low and stable.

However, at the same time, given the current high year-on-year growth of 17.8 percent in the broad money, the State Bank expressed concern over this approach, saying it would require more vigilance in the near future.

The government borrowed Rs567 billion from the banking sector and Rs590 billion from commercial banks alone between July and December. The money supply is at present expanding at an annual rate of 18 to 20 percent (14 percent last year) entirely because of huge government borrowing.

During July 1 to December 7, 2012, the net domestic assets of the banking system, as reported by the State Bank, saw an expansion of 7.8 percent and stood at Rs503 billion as compared to Rs331 billion, or 5.60 percent, last year. This acceleration in net domestic assets growth is mainly attributed to large budgetary borrowing from the banking channels. The fiscal deficit of Rs284 billion, or 1.2 percent, of GDP during the first quarter of FY13 was entirely financed by the borrowing from the domestic sources.

However, the net foreign assets were registered at negative Rs64.7 billion over the period under review.

The inflated growth of net domestic assets (NDA) of the banking system caused the broad money (M2) to expand at a higher rate.

The year witnessed monetary easing by a cumulative 450 basis points over the last 17 months. Discount rate has brought down by 250bps to a five-year low single-digit of 9.5 percent during this fiscal year, owing to decline in inflation rate. In August, the SBP slashed the policy rate by 150bps and then by another 50bps in October.

The consumer price index (CPI) inflation was reported at 6.9 percent, while core inflation measured by non-food non-energy remained in the double-digit, as it grows by 9.7 percent in November.

Resultantly, the benchmark six-month KIBOR came down to 9.4 percent (down 258bps in 2012), while during the same tenor six-month treasury bills and 10-year Pakistan Investment Bonds reduced to 9.3 percent and 11.5 percent, down by 263bps and 148bps, respectively.

The management of foreign exchange market was also proved challenging for the central bank during 2012. Stress prevailed in the foreign exchange market and on the domestic currency as the balance of payments position deteriorated on account of huge debt repayments to the International Monetary Fund (IMF) against its standby arrangement loan facility of $7.9 billion obtained in November 2008, said analysts.

Weakening foreign inflows and hefty debt repayments pushed Pakistan’s current account in the red again. Latest figures from the State Bank of Pakistan show that the country has run up a deficit of $365 million in the first five months of the current fiscal year.

This deficit comes on the heels of a modest surplus: improvements in the services account and strong remittances over the first four months of the current fiscal had thrown up a $258 million surplus.

Pakistan paid heavy debt repayments to the IMF during 2012. So far, Pakistan has paid over $2 billion to the IMF against its standby arrangement since February 2012.

Consequently, during the year, the country’s forex reserves depleted to $13.3 billion as against $17 billion at the start of January 2012.

The debt repayment has put enormous pressure on the country’s foreign exchange reserves, which have been on the decline for the last 16 months.

The country’s forex reserves fell by over $4 billion during the period, while that of the central bank declined by $6.2 billion from $14.8 billion at the end of June 2011 to $8.6 billion as on December 21.

Foreign direct investment inflows during the five months of FY13 declined to $305.6 million, while the country saw a net outflow of $304 million from the capital and financial accounts between July and October.

This situation resulted in exerting pressure on the rupee that continued to witness free-fall against the dollar. The rupee-dollar parity depreciated by almost Rs4 in July-December FY13. The rupee shed 120 paisas or more than 1.2 percent of its value against the dollar in just seven days between December 10 and 17, 2012.

The country witnessed a steep fall in the interest rates during the calendar year 2012, while the local currency posted an above average depreciation against the dollar. During the year, the local currency depreciated by 7.8 percent against the greenback, which compares unfavourably with last 10 years and 20 years average depreciation of 3.7 percent and 6.2 percent, respectively.

Downward pressure on the rupee also led to an increase in the foreign currency deposits of commercial banks. It showed some level of existence of dollarisation in the economy.

Outlook: Currency experts say that with the release of the much-needed foreign inflows of $688 million under the Coalition Support Fund on December 28 from the United States administration, the outlook for the Pakistan’s exchange rate seems positive to some extent in the year 2013. It would help the country improve its weak external account position but would also strengthen the exchange rate.

The economy would be able to build foreign exchange reserves to meet the due debt obligations at least in the coming year. However, the long-term outlook for the exchange rate remains precarious as Pakistan has to make huge repayments of $2.7 billion and $3.2 billion, respectively, to the International Monetary Fund in FY13 and FY14.

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