In its monetary policy for December and January, the central bank expressed concern over a number of issues directly or indirectly impacting the monetary management.

It said CPI inflation, which stood at 6.9 per cent last month, declined faster than earlier estimates, along with food, non-food and core inflation.

This broad-based deceleration in inflation is now expected to keep the average inflation below the 9.5 per cent target for FY13 (2012-13). “Therefore, the SBP has decided to reduce the policy rate to 9.5 per cent,” it said.

Sharp depreciation of the rupee against international currencies and a large monetary expansion were the two main reasons which influenced the monetary stance and forced the central bank to go for a small interest rate cut instead of a large one.

The decision did not go down well with business and industry as they were optimistic about a big cut in keeping with an unexpected decline in main inflation.

The State Bank said the overall stress in the external position was also increasing given the declining financial inflows and substantial debt repayments.

Led by direct and portfolio investment flows, the total net capital and financial account inflows had been on a declining path for some years now, the SBP said, adding:
“These inflows have come down from a peak of 7.2 per cent of GDP in FY07 (2006-07) to 0.7 per cent in FY12 (2011-12).”

The central bank said a low interest rate could potentially affect the credit demand, including that of imports, and return on rupee-denominated assets relating to foreign currency assets.

“The first consideration is not a source of concern, but the second consideration is important and puts a natural ‘limit’ on downward adjustments in the interest rate.”

The central bank attributed the large monetary expansion to a year-on-year growth of 26.4 per cent and fiscal borrowings from the banking system.

“Given the current high year-on-year growth in broad money of 17.8 per cent, this approach will require more vigilance in near future,” it said.

Almost all fiscal borrowings from scheduled banks and retirement to the SBP took place during the first quarter of FY13. In the second quarter, the fiscal authority has mostly relied on SBP to meet its financing requirements while just rolling over the maturing scheduled bank debt.

As per recent amendments to the SBP Act, the fiscal authority is required to ensure at least zero borrowing from the SBP in a quarter.

“Given that only two weeks remain before the end of the second quarter of the financial year, it seems unlikely that this requirement will be met,” the SBP said.

The fiscal authority borrowed Rs586 billion from scheduled banks between July 1 and Nov 30.

The fiscal deficit of Rs284 billion, or 1.2 per cent of GDP, during the first quarter (July-September) of 2012-13 was entirely financed by borrowings from domestic sources. Almost 91 per cent of last year’s fiscal deficit was also financed from domestic sources.

“A year-on-year growth of 62.5 per cent in interest payments on domestic debt in the first quarter of 2012-13 is not surprising,” the SBP said, adding that the consistently low level of credit availed by the private sector, together with declining foreign investments, were the main factors responsible for a stagnant economy.