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Identifier
Created
Classification
Origin
08ISLAMABAD2576
2008-07-30 12:55:00
UNCLASSIFIED//FOR OFFICIAL USE ONLY
Embassy Islamabad
Cable title:  

STATE BANK OF PAKISTAN RAISES KEY DISCOUNT RATE AS MULTIPLE

Tags:   ECON  EFIN  PREL  PK 
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RUEHNE/AMEMBASSY NEW DELHI 3587
RUEHLO/AMEMBASSY LONDON 8398
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RUEAIIA/CIA WASHDC
RUEKJCS/SECDEF WASHINGTON DC
						UNCLAS SECTION 01 OF 03 ISLAMABAD 002576 

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN PREL PK
SUBJECT: STATE BANK OF PAKISTAN RAISES KEY DISCOUNT RATE AS MULTIPLE
PRESSURES WEIGH ON THE ECONOMY

UNCLAS SECTION 01 OF 03 ISLAMABAD 002576

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN PREL PK
SUBJECT: STATE BANK OF PAKISTAN RAISES KEY DISCOUNT RATE AS MULTIPLE
PRESSURES WEIGH ON THE ECONOMY


1. (SBU) Summary: In an effort to curb rising inflation, the State
Bank of Pakistan (SBP) raised its key discount rate by 100 basis
points to 13 percent. SBP Governor Dr. Shamshad Akhtar defended the
Bank's decision, citing increased risks to the economy from rising
inflation and worsening current and fiscal account deficits. The
GOP's current fiscal year deficit target already appears untenable,
further complicating prospects for macroeconomic stability in the
short term. Inflationary pressure continues to weigh on the
economy; headline inflation reached a thirty year high of 21.5
percent in June 2008, coupled with a 32 percent rise in the cost of
food. Pakistan's business community has been critical of recent
monetary policy tightening, asserting that as the cost of production
rises, exports will become less competitive. End Summary.


2. (SBU) Citing multiple risks to Pakistan's macroeconomic
stability, including rising inflation and deteriorating fiscal and
current account deficits, the State Bank of Pakistan (SBP) raised
its key discount rate by 100 basis points to 13 percent. The July
29 decision is the fourth consecutive rate increase in the past
year; the Bank's discount rate was 9.5 percent in July 2007. The
move is seen as an attempt to contain aggregate demand, and
consequently, inflationary pressure. In announcing the decision,
SBP Governor Dr. Shamshad Akhtar opined that the Government of
Pakistan (GOP) would need to reduce borrowing from the SBP and
decrease the growth of imports, particularly fuel, in order to
achieve the Bank's goal of reducing inflation (Note: GOP borrowing
from the SBP reached an all-time high of Rs 689 billion (around USD
10.4 billion at the average exchange rate for the period) in the
recently concluded 2007-08 fiscal year. End Note). The SBP Central
Board of Directors also recommended that the GOP retire Rs 21
billion (USD 300 million) in debt owned to the SBP each quarter of
the current fiscal year, aiming to reverse the adverse impact of
record GOP borrowing from the State Bank.

BUDGET DEFICIT TARGET UNTENABLE?
- - - - - - - - - - - - - - - -


3. (SBU) The GOP's fiscal year 2008-09 budget projects a budget

deficit target of 4.7 percent of GDP (Note: Pakistan's fiscal year
runs from July 31 to June 30. End Note). However, this target is
based on the Finance Ministry's assumption that the FY07-08 deficit
was 7 percent of GDP; the State Bank estimates that the figure is
closer to 8.3 percent. The Bank has publicly stated that it
believes the Federal Government is underestimating spending and
overestimating revenue, making the 4.7 percent target untenable.
While the GOP has announced that expenditure growth will be capped
at 6.5 percent this fiscal year, government spending has risen an
average of 20.3 percent per year over the past five years.
Similarly, the GOP estimates tax revenues will increase by 24
percent this fiscal year, despite growing at only 12.8 percent per
year over the past five years.


4. (SBU) Despite multiple GOP pledges to reduce borrowing from the
State Bank of Pakistan, including one such promise made by Finance
Minister Naveed Qamar on July 22, the Government has already
borrowed Rs 32.9 billion (USD 470 million) in the first 25 days of
the current fiscal year. SBP officials caution that even a minor
deviation from the GOP's budget deficit target would have a profound
impact. The SBP estimates that a one percent increase above the
target deficit of 4.7 percent would require Rs 100 billion (USD 1.43
billion) in additional borrowing from the State Bank.

AGGREGATE DEMAND AND INFLATION BOTH CONTINUE TO RISE
- - - - - - - - - - - - - - - - - - - - - - - - - -


5. (SBU) The difference between real domestic aggregate demand and
the supply of goods and services widened in the recently concluded
fiscal year. Increases in both the current account deficit and
fiscal deficit are a manifestation of this widening gap. The SBP
estimates that real domestic demand grew by 7.1 percent versus a 5.8
percent growth in real supply, mainly driven by increased public and
private consumption expenditures. Real investment expenditures grew
at a subdued 3.4 percent. The rise in consumption also reflected a
drop in national savings, leading to a larger savings/investment
gap. The State Bank continues to believe that the level of real GDP
remains well above potential national output. In short, the total
of goods and services being produced by Pakistan's economy exceeds
what the country can sustain in the long run with stable inflation.


ISLAMABAD 00002576 002 OF 003




6. (SBU) Headline inflation reached a 30 year high of 21.5 percent
year-on-year in June 2008 while food price inflation rose to a
record 32 percent. Average consumer price inflation for fiscal year
2007-08 came in at 12 percent, well above a target of 6.5 percent.
Average food price inflation rose 17.6 percent for the year with
non-food price inflation rising 7.9 percent. A decrease in
productive capacity, continued strong aggregate demand, and the
multiplier effects of rising global fuel prices all contributed to
rising domestic inflation.

MACROECONOMIC INDICATORS TREND DOWN
- - - - - - - - - - - - - - - - - -


7. (SBU) Domestic macroeconomic imbalances, in part due to the
previous government's reluctance to reduce energy subsidies in the
face of rising global fuel costs, continue to reduce the current
government's options for dealing with Pakistan's economic woes.
International liquidity concerns, decreasing global growth and the
rising cost of commodities all impacted overall macroeconomic
health. During its 2007 preparation for the FY 2007-08 budget, the
GOP projected it would pay an average of USD 65 per barrel for
imported oil. Pakistan actually ended up paying an average of USD
86 per barrel, causing the current account deficit to swell. (Note:
Pakistan has a concessionary price deal for Arabian light crude from
Saudi Arabia and other regional producers. End Note) In addition,
the GOP had to swallow a USD 3.5 billion food import bill as
domestic agricultural production slumped and global prices rose.



8. (SBU) Decreased portfolio investment and lackluster privatization
receipts both contributed to a rise in the current account deficit,
despite USD 5 billion foreign direct investment (FDI) in the fiscal
year. Consequently, 30 percent of Pakistan's FY07-08 current
account deficit was financed by a USD 4.3 billion drawdown of
foreign exchange reserves, almost all of which occurred in the
second half of the fiscal year. Pakistan's foreign exchange reserve
import coverage fell from 31 weeks at the end of June 2007 to 17
weeks at the end June 2008. Reserve depletion, coupled with rising
investor pessimism, has resulted in a sharp depreciation of the
Pakistan rupee vis-`-vis the dollar.

REACTION FROM PAKISTANI BUSINESS LEADERS
- - - - - - - - - - - - - - - - - - - -


9. (SBU) Pakistan's business community has been critical of recent
monetary policy tightening, asserting that as the cost of production
rises, exports will become less competitive. Former Lahore Chamber
of Commerce and Industry president Anjum Nisar remarked that the
rate hike was unlikely to stop inflation but would increase the cost
of borrowing and consequently, business operations. State Bank
auditors reviewed financial data from several non-financial sector
companies listed on the Karachi Stock Exchange. They found that, on
average, financial expenses constituted only 2.4 percent of overall
corporate costs, versus 4.7 percent in 2001. In 2007, average
corporate costs grew by 12.1 percent while financial expenses grew
by 0.7 percent only, refuting private sector claims.

COMMENT
- - - -


10. (SBU) Comment: The unsustainable fiscal deficit target does not
bode well for Pakistan's future macroeconomic stability, its credit
rating or its ability to attract significant new investment.
Multiple internal and external funding constraints make the
financing of an even larger fiscal deficit unlikely. Excessive
borrowing from domestic sources, including the State Bank, may
reduce credit available for the private sector, further hampering
already low investment growth.


11. (SBU) Comment Continued: Pakistan's consumption-led growth of
recent years has finally led to spiraling inflation. Expenditures
and imports, particularly of fuel, must be contained now. By
quickly and effectively addressing structural constraints in
multiple sectors of the economy, Pakistan may be able to improve
productivity, particularly in lagging industrial and agricultural
sectors. Improving long-run factor productivity remains crucial to
ensuring both price stability and long-term sustainable growth.
However, in the short term, Pakistan's dwindling foreign currency

ISLAMABAD 00002576 003 OF 003


reserves are a real concern. Whereas Post contacts would laugh off
the prospect of an emergency International Monetary Fund (IMF)
program only months ago, the sentiment is starting to change. For
some, it has become a question of when, not if, international
financial institutions will have to come to the rescue. End
Comment.

ARCHIBALD