5.1.1 Overview

 

While monetary policy continued to be dominated by ongoing growth in Net Foreign Assets (NFA) due to the external account surpluses, FY03 also saw important changes from the trends in the preceding year. During FY02, even the cumulative 500 basis point discount rate cuts had garnered only a 185 basis point reduction in the weighted average lending rate, and net private sector credit growth remained weak. Therefore, duringFY03, in response to the continuing weakness in net private sector credit, the SBP chose instead to increase market liquidity by substantially reducing the sterilization of its rising forex market purchases (see Table 5.1), and then reinforced the resulting interest rate decline through its November 2002 discount rate cut.
 

Table 5.1: Sterilization

 

 

As a result of the increased market liquidity and the SBP policy signals, domestic interest rates plunged to all-time lows. This supported a revival in economic activity and eventually contributed to the stunning Rs 167.7 billion net private sector credit expansion during FY03 (see Figure 5.1), which underpinned the 18.0 percent monetary expansion during the year, against the relatively lower 15.4 percent increase in FY02.

 

Specifically, the FY03 growth in net private sector credit is unusual not only because of its magnitude, but also in its composition:

 

(1) Approximately one-third of the net credit growth stemmed from a sharp rise in trade related forex (FE-25) loans (see Section 5.1.4 for details);

 

(2) The consumer finance rose sharply from Rs 10.7 billion in FY02 to Rs 45.1 billion in FY03 (see Box 6.2 for details); and,

 

(3) Less importantly, the exceptionally strong acceleration in credit during Mar-Jun 2003 probably incorporates the surge in lending against NSS instruments, as investors sought to take advantage of interest rates differential. Interestingly, given that the increased FY03 market liquidity stemmed primarily from the SBP's efforts to moderate the ascent of the rupee (in order to support exports), it can be argued that it was the exchange rate which effectively constituted the nominal anchor for monetary policy during the year, in contrast to FY02, when this role was served by the discount rate.

In fact, after bringing down the discount rate to a record low of 7.5 percent in November 2002, the SBP thereafter kept it unchanged despite an increasing spread to the benchmark 6-month T-bill rates (see Figure 5.2). There were essentially two reasons for this policy:

 

(1) Initially, the SBP aimed to discourage speculative investments in government papers; and

 

(2)        Subsequently, this stance was supported by a desire to avoid further pressure on the already-sliding market rates.

 

Unfortunately, the exceptionally liquid market and expectation of a continued pressure on interest rates effectively meant market interest in government securities continued to grow, and ultimately rendered the discount rate ineffective as an instrument of monetary policy, leaving it simply as an indicator of the SBP's monetary stance.

 

The interest rate expectations driving the increasing investment in government papers and consequent decline in benchmark interest rates, in turn, it was supported by an apparent misinterpretation of the SBP policy. Despite clear and repeated assertions to the contrary, the market felt that the rising market liquidity stemmed not from SBP policy decision, but from its inability (and unwillingness) to sterilize the flows due to a sharp reduction in SBP T-bill holdings¹. As a result, T-bill yields dropped very close to the yields on comparable dollar interest rates (see Figure 5.3), offering negative real rupee returns.

 

It is important to note here that the strategy of partial sterilization, while quite successful in drawing down the interest rates during FY03, is not sustainable in the long term.   In particular, historical evidence strongly suggests that an exceptional growth in money supply does indeed eventually engender inflationary pressures. Thus, in light of the fact that interest rates are already at historical lows, FY04 will likely witness a re-focusing of SBP policy on the pre-payments of expensive external debt in order to sterilize the impact of future external account surpluses to head off inflationary pressures.

 

5.1.2 Monetary Survey

As in the preceding year, FY03 witnessed extremely strong growth in monetary assets (M2) due to exceptional increases in the net foreign assets of the banking sector; as a result, M2 rose 18.0 percent during the year, even on the high base due to the exceptional 15.4 percent M2 growth during FY02 (see Table 5.2). Moreover, all of the NFA increase is attributable to a rise in the SBP NFA, while the NFA of scheduled banks fell by Rs 19.4 billion (reflecting the impact of their foreign currency lending out of their FE-25 deposits).

 

Table 5.2: Monetary Survey of the Banking System (Flows)

 

 

In contrast to the NFA picture, growth in the Net Domestic Assets (NDA) of the banking system was subdued in FY03, since both 'government borrowings for budgetary support' and 'commodity operation loans' witnessed heavy net retirements, offsetting much of the phenomenal rise in net credit to the private sector. The government borrowings for budgetary support resulted from the government's improved fiscal position because of higher revenues, greater availability of cheap external financing, larger non-bank borrowings, and all of which helped the government retire Rs 56.0 billion in net credit, in contrast to the net borrowing of Rs 14.3 billion in FY02. The fall in commodity operation loans, on the other hand, also mirrored the rising wheat exports and increasing availability of bank credit to the private sector for wheat purchases.

 

Another notable feature of the budgetary borrowings is the continuing decline in borrowings from SBP that partially offset a rise in borrowings from scheduled banks. This switching mainly represents the SBP monetary sterilization, as SBP continued retiring its T-bill holdings to neutralize the impact of its forex purchases.

 

Other items net (OIN) of the banking system continued to shrink but the adjustment in FY03 was greater than in FY02 (see Section 5.1.9 for details).

 

Finally, the Reserve Money (RM) growth was curtailed to 14.5 percent, lower than monetary expansion of 18.0 percent during FY03, which marginally increased the money multiplier to 3.1 from 3.0. This owed principally to the SBPs monetary sterilization efforts; RM expansion would otherwise have ballooned by a massive Rs 291.1 billion during FY03.

 

Table 5.3: Credit Plan for FY03

 

 

 

5.1.3 Credit Plan FY03

 

The FY03 Credit Plan initially targeted a Rs 190.0 billion monetary expansion, of which Rs 91.5 billion was envisaged to be through money creation due to external sector developments and the rest was through domestic credit creation (see Table 5.3). However a few developments in first few months of FY03 led to the adoption of a revised credit plan in the mid-year National Credit Consultative Council meeting. These developments included:

1) A better than expected fiscal position of the government;

 

2)     Unexpectedly large retirement of commodity operation loans; and