These have helped reduce current account deficit sharply as Pakistan received record remittances of dollar 9 billion. In 2010, Currency Market Associates (CMKA) is expecting a discount rate hike of 100 basis points and rupee could lose 6 percent of its value against dollar.
Easing of inflationary pressure, helped the central bank to slash its discount rate by 250 basis points to 12.5 percent. CPI briefly touched the magical single digit figure. The fall was due to some efforts made by the central bank, as bigger factor in containing inflation was the base effect. No extraordinary steps were taken by the fiscal planners that could have left a lasting impact on inflation slowdown, which has started to creep up again.
A cut in discount rate eased off pressure on 6-month Kibor that fell to 12.43 percent from the highs of 15.68 percent. And, six-month Treasury bill yield gained 190 basis points to close at a yield of 12.1 percent.
Similarly, yield of 10-year government bond (most actively traded instrument) was dealt at a yield of 14.9444 percent in January 2009. A sharp gain was witnessed on expectations of discount rate cut and demand from corporate sector that pushed yield to 11.44 percent before easing on fear of thin corporate demand in 2010. It closed at a yield of 12.65 percent.
Recent economic indicators may suggest that Pakistan's economy has started shaping up well, but we have some legitimate doubts on the existence of such trends because we are unable to identify real economic gains. Inflation numbers may have dipped sharply, but the cost of doing business and prices of essential items continue to remain a worrisome factor.
Pakistan's economy:
CMKA is forecasting quite a mixed bag of economic growth, as the economy is dependent on foreign donors funding. A grave risk for 2010 lies in rising commodity prices, since oil and food could be the key factor and it has the potential to feed inflationary expectations. Export sector is unlikely to take a big stride unless some innovative measures are taken.
To meet the fiscal deficit target and reduce government borrowing, banks will be encouraged to invest in Tbills and government bonds. Against the Tbills maturities of Rs 750 billion in the last two quarters of FY10, we are expecting increase in Tbills target amount to Rs 800 billion and additional target of Rs 30 billion in PIBs against zero maturity has already been announced. Therefore, a 3 percent GDP growth target would be tough, unless excess liquidity is made available to the banking system.
Fiscal deficit is another key number to watch. In our view, a deficit target of 4.9 percent of the GDP set by the IMF is unfair and too demanding and is difficult to be met with the projected growth rate. This would continue to choke economy and hinder growth prospects in private sector while pressure will mount on the revenue target.
Domestic debt and external debt are the major cause of concern. Domestic debt outstanding surged to Rs 4.230 trillion a jump of Rs 675 billion against last year's Rs 3.555 trillion while external debt surpassed dollar 55 billion marks for first time. Annual average cost of domestic financing is roughly 12 percent, this would cost the exchequer around Rs 500 billion and foreign borrowing would roughly cost dollar 3 billion, which means an amount of Rs 750 billion is required to finance the deficit. We are deeply concerned over the rise in un-funded debt to Rs 1.355 trillion from Rs 1.06 trillion, which requires immediate attention.
Inflation:
Inflation risk has re-emerged, which could once again put pressure for a discount rate hike, as we see fiscal year end y-o-y CPI inflation surpassing 13 percent. We are expecting a 3 to 4 percent surge in inflation numbers by the end of June.
There is a growing fear that with the surge in global growth, demand for food will increase, pushing food prices higher.
Similarly, global growth will create more demand for oil, which would push oil prices higher. An average price of oil beyond dollar 80 per barrel will not be sustainable for our economy. Hence, the need for an oil hedging strategy.
Another inflationary factor that needs to be checked quickly is constant growth in currency in circulation. In six months, it grew by Rs 187.7 billion to Rs 1.34 trillion. We do not expect money growth to halt in the near term due to domestic food price spiral, which also suggests that more cash will be required to meet our daily needs.
In our view, the SBP is in a Catch 22 like situation, as it has been caught between a severe liquidity crunch situation and high inflation. Despite committing to IMF to maintain its tightening stance until inflation is brought down to its desired levels, the Central Bank is forced to pump liquidity in the interbank market through its open market operation injection. We believe there are two factors behind this strategy. First, it is aimed at managing daily business affairs, and secondly, injection becomes mandatory obligation to fulfil commitment to IMF of Tbills target. The SBP lending through OMO roughly averages around Rs 100 billion and another amount of Rs 150 billion is injected through DollarRe, buysell swap, which ultimately negates the Central Bank's aim of policy tightening.
In our view, the phenomenon of constant liquidity injection is one of the major causes of high banking spread of over 7 percent and a worrisome rise in currency in circulation. Banks are fully aware that they are comfortably placed. Knowing SBP's commitment to IMF they are investing excess funds in government securities instead of providing loans to private sector while the SBP has no choice, but to provide them the required funds to meet Tbills target. Depositors shy away from putting their money in banks due to low return offered to them, which results in a constant rise in currency in circulation.
If tightening is done in the real sense of the word, then banks will be forced to offer attractive returns to depositors. Only will attractive returns bring a large part of money back to banking sector. It will also help in pushing up the much needed country's savings ratio higher.
Liquidity:
For the last 11 months, banking system has been witnessing excessive tightening condition and to meet the rupee shortfall, the SBP has been injecting funds in the interbank market through its open market operations (OMOs) on a regular basis. On November 27, 2009, the Central Bank injection touched the highs of Rs 166.7 billion.
The liquidity squeeze is also due to rising NPLs that has jumped to Rs 435 billion. The currency in circulation has not been of much help. Although, it is on a constant rise for the last four years, the SBP has been unable to effectively check this trend. Tight liquidity conditions are considered as one of the major causes of slow growth.
There is very little hope of respite as domestic liquidity crunch is most likely to stretch for a longer duration if an extraordinary external support is not received. Healthy revenue collection can also provide some relief, but we are not expecting a big breakthrough.
Hence, we are expecting more compromises and more adjustment entries such as settlement of circular debt, which may be a good temporary solution, but not the plausible answer to the ongoing problem.
Exchange rate:
Despite a sharp fall in the current account deficit and record home remittances rupee lost 6.5 percent of its value against dollar to close at 84.24. On January 01, 2009, one dollar would fetch Rs 79.1. It is understandable that as long as the large part of foreign exchange reserves consists of borrowed money, external debt keeps on piling up and exports growth remains quite disappointing, the rupee is bound to come under pressure. Since we do not see high export growth prospects, a broader risk to rupee could arise from rising commodity prices in the international market that could ultimately exert pressure on the current account deficit.
Therefore, in the first two quarters of 2010, rupee is likely to lose its gloss against dollar by two percent, and another four percent by the end of December.
Trade and current account deficits. A substantial fall in current account deficit in the last five months is very encouraging. This was possible due to a significant fall in imports and a one-third rise in remittances. The fall in import of food items was mainly helped by drop in wheat import. The fall in palm oil price was by dollar 691 million. A drop in the purchase of machinery products helped reduce deficit by dollar 654 million and a large fall in purchase of petroleum products and crude oil pushed deficit down by another dollar 1.88 billion. Big fall in oil bill was the result of softer oil prices in international market. In six-month period (July-Dec) average cost of oil purchase was dollar 68.5 per barrel against the budgeted price of dollar 73. This also means an average price of dollar 77.5 per barrel for the next six months is sustainable for the economy.
In the next two quarters, import bill could come under pressure due to sugar buying, which is trading at a record high price. Similarly, rising trend of oil prices in the international market does not bode well. We estimate that Pakistan's import could close around dollar 32.5 billion.
Despite a good rice crop, export receipts will remain disappointing. A drop was also witnessed in the leather sector, which requires attention.
Textile sector, which is considered as the backbone of economy and a flagship of exports, has once again failed to cope up with the pace due to numerous negative factors, which needs quick attention. Since textile contributes over 60 percent of the overall export target, we expect a drop in net export target of dollar half billion to one billion. CMKA is optimistic about home remittances are most likely to surpass dollar 9 billion.
FDI is unlikely to make big strides for the second consecutive year and may remain around dollar two billion. Therefore, the current account deficit for FY09-10 would be close to dollar three billion.
Revenue collection:
Meeting revenue target has always been easier than to raising Tax-to-GDP ratio, which is the major cause of rising domestic debt. A sustainable economic growth is the dire need to avoid future economic disasters, which is not possible without a strong tax base.
Pakistan has a history of poor tax-to-GDP ratio. It ranges between 8.5-11 percent and with current dismal rate of 8.5 percent Pakistan has slipped down to last 25 in the list of 175 countries. It was in the 90s that Pakistan's revenue collection hit the much-desired level of 13 percent.
Pakistan needs to broaden the tax net base. The government should tax all income groups. The ratio of direct taxpayers need to be increased from current 40 percent to over 50 percent at a fast pace to avoid further damage to the economy.
Based on population, which is 170 million, if the large part of the wealth is in the hands of 5 percent of the population, even then the number of taxpayers should be over 8 million, whereas taxpayers' percentage is hardly 1.5 percent. Unless the intentions are honest and country's overall tax structure is revolutionised and the big figure cheques of six million people that go unaccounted is brought into tax net the economy will remain in doldrums.
IMF's recommendation to introduce Value Added Tax (VAT) through parliament may be a step towards a right direction as it is considered as an important source of revenue abroad. In the past, the attempts to implement GST faced strong resistance from the retailers. Therefore, the implementation VAT may not be easy now, and unless all classes are brought into the tax net, justice will not be done.
At the current pace of tax collection, the deficit would continue to rise. The country will remain dependent on foreign borrowings, government borrowing will not reduce, printing of currency notes will be unavoidable, inflation will continue to haunt people and circulation of money will continue to rise. Rupee would continue to fall against the dollar and ultimately it will certainly lead the country to a debt trap.
Agriculture and livestock:
Agriculture is a pet subject of every government. This could be more due to personal interest of parliamentarians because either they are mainly owners of large farm tracts or mills. Practically, there has been no remarkable achievement in terms of higher yield per acre. If wheat and rice production has increased it is mainly due to support price attraction at the cost of sugarcane, lentils, potatoes, etc.
There is a huge risk of food shortages and price hike in 2010. Planners need to be cautious while allocating quotas. Support price culture should be abolished and prices should be based on real market trends.
Farming mechanism is still outdated and poor. With modernisation, growth could be doubled and export earnings could make a big leap. Almost half of the fruits and vegetables go bad by the time they reach consumers. Warehouses, refrigeration and storage facilities should be the first priority to increase export of these items.
The potential of fish farming remains unexploited. Funds should be made available for fish farming and foreign experts should be hired to groom the locals.
Livestock remains one area that requires more attention. This year's prospects of increasing meat and meat products could be encouraging if the required efforts are made. Output can be increased by between five percent to eight percent on reports of good weather and pasture conditions in Pakistan.
Pakistan is the 5th largest producer of milk and expected to produce 33.2 million tons of milk. More than 40 percent of milk is being wasted due to non-availability of chillers. If the country is able to modernise its milk industry, dairy industry can penetrate international market.
Meanwhile, poultry industry requires some sort of incentives, as in the last two years over one-third of poultry farmers are reported to have either scaled down production or closed down operations. Poultry is prone to disease outbreak. The industry can do well if it seriously takes into consideration this profound risk associated with poultry business.
Global economy:
Global financial market continued its struggle for the second successive year, though lately it has shown some signs of recovery. The US currency's share of foreign reserves held by global central banks dropped to 61.6 percent, ten years ago the share of dollar was 72 percent.
The IMF is projecting a slight increase in global growth from its earlier forecast of 1.9 percent. Estimates for 2010 for the global growth range between 2 percent to 2.5 percent.
Some of the banks in the US are doing well after nationalisation. There is also report of a big tax relief given to corporations. Changes allowed to make accounting adjustments to avoid collapse were also a helping factor. It is also true that recent economic gain is the result of sponsorship of stimulus package by the world central banks.
The current environment around the globe is not very encouraging in economic sense, as the financial uncertainty is still looming all over the places due to excessive risk taking culture, resulting in a serious credit crisis.
Signs of cracks are emerging from the European market, though Asia may have a different story to tell. The recent events that took place in Greece and Dubai are evident of the fact that such happenings can cause severe impact on the global economic activity.
However, keeping in view the overall economic conditions, an excessive volatility should not be very surprising. One thing is for sure that cash is short and liquidity crunch will stay for a longer period of time.
Oil WTI-$79.36:
The fundamentals of crude oil may point to a weaker demand for oil this year, but there are many factors that also support the bullish sentiment.
Considering these fundamentals, there are many reasons to believe that the supply is in abundance. Non-compliance of quota could be the big factor, Opec members are said to be overproducing by roughly 800,000 barrels per day. Output that fell in Western Siberia is due to pumping at maximum. Brazil, Columbia and the US are producing in excess. The Caspian Sea is over producing. Overall non-Opec countries are said to be producing 570,000 barrels per day in excess.
Similarly, Int'l Energy Agency predicts fuel consumption to rise by 1.7 percent or 1.4 million barrels per day. There is a legitimate that an increased demand for oil would be seen from China and India and if the US economy starts performing well the demand will be much higher because it currently consumes 24 percent of the global oil. The last thing to note would be that if the global demand grows and Opec decides to hold back oil production, then oil will certainly hit dollar 100 for the second time. We are expecting oil to average above dollar 78.
Euro 1.4231:
Year-end late dollar rally is a common occurrence due to book squaring, but this year the dollar bulls had a genuine reason to celebrate. Fed's stimulus package backed by quantitative easing and zero interest rate environments seems to have clicked. The evidence becomes obvious as USA's 3rd quarter GDP increased by 2.2 percent and the economy still managed to pull itself out of the decline that had prevailed during the previous four quarters.
We are of the view that there would be a plenty of positive news for dollar, though the US economy may be facing some hiccups during its 2010 journey. Stimulus measures so far taken may halt or stabilise the US unemployment rate.
Fed has signalled that it could make early exit from credit easing. This may not happen soon, but it has given hopes that the US Central Bank is now becoming concerned with its prolonged low rate policy and Fed's overnight rate could soon enter the positive zone.
Meanwhile, Europe seems to be encountering bigger problems. Greece, Spain, Italy, Hungary, Latvia and Ireland are all suffering from debt and unemployment mania and they have borrowed heavily from German and Swiss banks. Some of the banks are insolvent and some are on the verge of insolvency.
Borrowed money in the US was also used for carry-over trade and invested in high yielding instruments. Also, if the money borrowed from the US and invested in Dubai and Europe is not settled at the time of maturity, it would lead to compound the present liquidity crunch, which means a rising demand for dollar.
So, we have enough reasons to believe that dollar rally would continue, with occasional large dollar corrections, as US economy has its own multiple problems. Technically, euro will give strong resistance at 1.4730 and only break would encourage for 1.5280, a scenario we do not favour and if seen should be used as an opportunity to go along US dollar. We are looking for a break of 1.3920 for a test of 1.3720. A convincing break would lead to 1.3180.
GBP 1.6163:
The UK economy is still in recession, due to housing sector debt and tighter credit conditions. In 2009, the economy contracted by 4.5 percent, though Confederation of British Industry (CBI) in its latest forecast has shown optimism by forecasting a 1.2 percent GDP growth in 2010. We believe that the growth will remain fragile and subdued.
A deeper look into the value of Pound Sterling against the basket of trade-weighted currencies since 2007, it shows that the British currency is down by 24 percent, which makes British goods relatively cheaper. But UK exports are still unable to catch the market. Pound faces significant problems due to a sizable budget deficit. Hence, it requires enough funding. In the run-up to elections, there is no single party that can win majority of seats in parliament. Furthermore, a recent survey shows that the ruling Labour Party is trailing behind the opposition Conservative Party.
It suggests that Pound Sterling will come under severe pressure and is likely to lose 15 to 20 percent of its value against dollar and euro.
Pound has strong resistance at 1.6480, should hold for a downside break of 1.5650. A break here paves way for 1.5240, which is a strong support zone. Once this area surrenders, a sharp fall towards 1.4980 will be seen. Our target for 2010 is 1.4120 or 1.6740.
JPY 93.10:
Japan's economy that faced a very long period of recession is now suffering from deflation. It also faces a widening trade deficit, which means Japan's economy may not see a rate hike in 2010. This also means that BOJ will persist with its near zero interest rate policy.
CMKA is expecting a volatility in yen. We are looking for a test of 97.90 and clean a break would encourage dollar to test 103.50. We are for a well thought out approach between 103.50 and 106.50 for a 10 percent gain. Else, a break of 89.20 could take the yen to touch a new high of 85.30 against dollar.
Copyright Business Recorder, 2010