New York May 7 2022: As Current Account (CA) deficits widen and liquid reserves dwindle, it is imperative for Pakistan’s policy mix to turn restrictive in order to engineer a necessary economic slowdown to avert a full-blown BOP crisis, reported by JP Morgan in its research report.
In this regard, the SBP has demonstrated a commitment to policy orthodoxy by delivering an aggressive 250bps rate hike earlier this month, bringing the forward-looking real interest rate to “slightly positive” territory (Figure 6). The return to targeting real interest rates, at least during a period of financial volatility, is crucial in providing the markets with a sense of policy credibility.
The question now is if the 250bps move is sufficient to manage CA pressures via import compression. During the last tightening cycle in 2018-19 when the real policy rate was raised from a trough of 0.8% to a peak of 4.9% (delta of 410bps), the CA deficit narrowed by US$5.4 billion or 1% of GDP, led by a contraction in fuel, metals, and textile import volumes. If the policy rate remains at 12.25% through FY23, we project the increase in real policy rate to be at 620bps (from -1.7% to 4.5%).
Despite this larger tightening, high positive real policy rate circa. 4% will likely only be achieved in 4Q22 when headline inflation tapers off. In addition, oil import prices will be materially higher in this cycle (average Brent: US$97pbl), compared to the previous cycle (average Brent: US$68pbl). These factors could dilute the efficacy of monetary tightening to reduce CA deficits in a timely fashion.
