STATE BANK OF PAKISTAN ANNOUNCES TIGHTER

UNCLAS SECTION 01 OF 03 ISLAMABAD 001953

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: EFIN ETRD ECON PREL PK
SUBJECT: STATE BANK OF PAKISTAN ANNOUNCES TIGHTER
MONETARY POLICY; STOCK MARKET SUFFERS SHARP LOSSES

Summary
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1. (U) Summary: The State Bank of Pakistan Governor Dr. Shamshad
Akhtar announced a series of measures to tighten monetary policy,
drain excessive liquidity from the system, and decrease imports to
firm up the rupee in a May 22 speech. Most of the new measures,
which are effective immediately, are designed to stem further
increases in the current account and fiscal deficits and to rein in
inflation. These measures include: a requirement that importers put
a 35 percent down payment to open letters of credit (except for food
and oil imports),a 150 basis point (1.5 percent) increase in
discount rate to 12 percent, and a 100 basis point (one percent)
hike in the statutory liquidity ratio and cash reserve requirement
to 19 and 9 percent respectively. In addition, all banks must pay
five percent interest on savings deposits beginning June 1. The
Karachi Stock Exchange KSE-100 index lost 615.26 points on May 23,
its second largest decline. End Summary.

SBP tightens monetary policy again
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2. (SBU) State Bank of Pakistan (SBP) Governor Dr. Shamshad Akhtar
announced a series of measures to further tighten monetary policy
in a May 22 speech. The SBP normally issues monetary policy
statements twice a year, in January and in July. However, the
widening current account and fiscal deficits, soaring food
inflation, and steady depreciation of the rupee forced the SBP to
act in advance of formulation of the new budget. The SBP hopes that
these new measures will slow inflation, reduce aggregate demand, and
stabilize the exchange rate.


3. (U) The new measures include:

-- a 150 basis point (1.5 percent) increase in the SBP's discount
rate to 12 percent effective May 23, 2008;
-- an increase in the Cash Reserve Requirement (CRR) for all
deposits up to one year maturity by 100 basis points (one percent)
to 9.0 percent;
-- maintaining the CRR for deposits of over one year maturity
unchanged at zero percent;
-- an increase in the Statutory Liquidity Requirement by 100 basis
points (one percent) to 19 percent of the total time and demand
liabilities; and
-- imposition of 35 percent letter of credit cash margin on all
imports except for oil and food. (Note: Previously importers could
open a letter of credit with no cash down. End note.)

Banks Required to Pay Higher Rates on Deposits
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4. (SBU) In an effort to encourage savings deposits, the SBP will
require that all banks pay a minimum five percent interest rate on
savings products effective June 1. Savings deposits constitute 63
percent of the total number of countrywide deposit accounts. The
interest rate for saving accounts was 2.1 percent. (Comment: The
real interest rate for savings will still remain negative due to the
increasing inflation rate. Pakistan has very few profitable savings
vehicles for individuals unwilling to risk the stock market. End
comment.)

Current account deficit unsustainable
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5. (SBU) The SBP projects the current account deficit in the range
of 7.3 - 7.8 percent of GDP, which is much higher than the initial
projection of 5 percent for FY08. The rising current account deficit
indicates that, despite decent export performance, significant
import demand pressures still exist. Oil, food and textile inputs
account for 43.4 percent of imports, and international prices for
these commodities have been increasing steadily. Agricultural
inputs represent another 15 percent, and machinery exports account
for 16.3 percent of imports. (Comment: Press reports frequently
blame the current account deficit on "luxury imports." Since the
majority of Pakistan's imports are food, fuel, inputs, or machinery,

ISLAMABAD 00001953 002 OF 003


there appears to be little justification for this argument. End
comment.)

Drop in foreign inflows
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6. (SBU) The GOP assumed growth in foreign exchange inflows when it
made its FY08 balance of payments projections, given FY07's positive
results. However, liquidity constraints in global financial markets
and the domestic political uncertainty have negatively impacted net
foreign inflows. The growing external current account deficit along
with slowdown in foreign direct investment and foreign portfolio
outflows has resulted in drawdown of reserves by USD 3.7 billion
from July 1 - May 16.

KSE-100 loses 615 points
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7. (SBU) The Karachi Stock Exchange KSE-100 lost 615.26 points to
close at 13,011.74 on May 23. This was the second largest KSE
decline. Market capitalization declined by USD 2.7 billion. Market
volumes were also down, with 154.75 million shares traded on May 23,
compared to 191.5 million May 22. The KSE-100 index lost 1221.15
points during the week of May 19-23. Analysts ascribed the near
record losses to the SBP's measures to decrease liquidity and
continued political uncertainty.

Exchange rate depreciates significantly
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8. (SBU) Decreasing foreign inflows combined with speculation in the
foreign exchange market have led to the rupee's 14.9 percent
depreciation from July 2007 to date. Since April 1, the rupee has
depreciated by over 11 percent. According to the SBP, tighter
monetary policy and structural changes to limit the GOP's ability to
use the Central Bank to fund its fiscal deficit should help stem the
rupee's decline.


9. (SBU) Pakistan's budget deficit is projected to be significantly
higher than the original FY08 budgetary estimates. By December 2007
(latest available data),the budget deficit had grown to USD 5.1
billion (Rs356 billion),nearly the entire full year USD 5.7 billion
(Rs399 billion) target. The stock of outstanding GOP treasury bills,
an instrument through which government borrows from SBP, has reached
USD 13.66 billion (Rs945.9 billion),or almost 9.4 percent of GDP).
This is the highest level in Pakistan's 60 year history, and is more
than double last year's level of USD 6.53 billion (Rs452.1 billion).
As a result, the SBP's efforts to manage monetary policy have been
made more difficult.

Inflation doubles
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10. (SBU) Overall inflation has almost doubled in last four months,
rising from 8.8 percent in December 2007 to 17.2 percent in April

2008. More disturbing is the increase in food inflation, which rose
to 25.5 percent from 12.2 percent during the same period. Non-food,
non-energy inflation has jumped from 7.2 percent in December 2007 to
10.8 percent in April 2008. The SBP expects inflation at over 11.0
percent for FY08, substantially higher than its FY08 target of 6.5
percent.

Amend the Fiscal Responsibility Law
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11. (SBU) The State Bank has advised the government to amend the
Fiscal Responsibility and Debt Limitation Act 2005 to incorporate
appropriate provisions to limit the GOP's ability to borrow from the
SBP. The GOP has continued to borrow from the central bank outside
this legislation, eroding fiscal discipline and making it difficult
to effectively tighten monetary policy. In FY08, the SBP has
financed approximately 80 percent of the GOP fiscal deficit.

Comment
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ISLAMABAD 00001953 003 OF 003




12. (SBU) Comment: The GOP faces a dilemma to preserve growth,
attract continued foreign inflows, and close its fiscal and current
account deficits. The SBP is trying to do its part, but its new
measures are likely to have little impact if the GOP does not impose
fiscal discipline in the new budget. Past efforts at tightening
monetary policy -- as recently as the January 2008 1.5 percent
interest rate increase -- have been undercut by the GOP's inability
to rein in spending and continued increases in international
commodity prices. Until Pakistan can implement significant energy
saving measures or bring on-line new energy sources, its fuel import
bill will continue to rise. The GOP's ability to continue to phase
out energy subsidies will be key to resolving its fiscal woes, but
is likely to cut growth. The new budget, which should be released in
early June, will be key to answering how Pakistan plans to resolve
its growing economic problems. End comment.

PATTERSON