LAHORE: The State Bank of Pakistan on Saturday raised the key interest rate to 7.5 percent for the next two months, an increase of 100 basis points.

This is the third rise in the key interest rate since the start of 2018 shows an increase in inflationary pressure and current account deficit have an impact on the country’s economy.

In January, the central bank had raised the key interest rate by 25 basis points and was again increased by 50 basis points in May to 6.5 percent.

A press conference held on Saturday witnessed the SBP governor Tariq Bajwa saying the country was facing near-term challenges, implicating the burgeoning trade and current account deficit that have dwindled the foreign exchange reserves.

Mr Bajwa said, “In the medium to long-term, the economy will remain on track.”

A press release issued by the central bank said it projected the provisional fiscal deficit to touch 6.8 percent for FY18 compared to 5.5 percent in May 2018.

SBP said the current account deficit rose to $16 billion during first eleven months (July-May) of FY18 compared to $11.1 billion in the corresponding period of FY17.

It added this meant the aggregate demand proved to be higher than previously expected.

While speaking to Profit, Maha Jafer Butt Director Research Capital Stake said “The announcement was no surprise. After widening current account deficit and falling reserves, increase in inflation comes as another challenge for the economy. The rise in rate comes after inflation rates are expected to miss targets with a devaluation of the currency and surge in international crude oil prices.”

Inflation on a year-on-year basis in June clocked 5.2 percent and average inflation for current FY19 is expected to surpass 6.0 percent annual target, said SBP.

Moreover, core inflation numbers and the one-year ahead estimates at around 7 percent are reflective of demand pressures, said the central bank.

Lastly, on the external front, the SBP said remittances and exports are performing better, but the sheer volume of imports was continuing to burden the foreign exchange reserves.

Although the real-economic activity replicated its strong FY17 performance, by the end of FY18 some challenges cast clouds on the ability of the real sector to continue treading this high growth path, said SBP.

In a comment to Profit, Saad Hashemy Director Research Topline Securities said “State Bank has highlighted expanding external and fiscal deficits and rising inflation as key reasons. We believe rates will further increase by 100 basis points by December.”

Regarding the agriculture sector, the central bank voiced concerns over water shortage which it projected would lead agriculture production below its target for FY19.

According to SBP, the “manufacturing sector was also poised to show a mixed picture owing to high base-effect, the on-going monetary tightening and some sector-specific issues whereas construction allied industries are likely to perform at par. Taking stock of these developments and the spillover on the services sector, SBP projects FY19 GDP growth to be around 5.5 percent as compared to the annual target of 6.2 percent.”

Elaborating about CPI, average headline inflation for FY18, the central bank said it stood at 3.9 percent for the just concluded FY18.

“However, this picture is changing rapidly as is visible from rising (YoY) headline and core inflation for June 2018 at 5.2 and 7.1 percent, respectively. Based on these recent estimates, SBP’s model-based range for average CPI inflation is 6.0–7.0 percent for FY19,” said SBP.

As per SBP, monetary expansion during FY18 was fueled by government borrowing for budgetary support purposes and a healthy rise in credit to the private sector.

Despite a decline in fixed investment and with problems surfacing in sugar and fertilizer sectors, the stock of private sector borrowing rose by Rs768 billion during FY18, clocking an annual growth of 14.8 percent.

Also, the central bank projected private sector credit to show an almost similar amount in a growth rate of around 13 percent.

It said this would be fueled primarily by an increase in the need for working capital at the back of gestation of lagged fixed investment into production and rising exports.

Also, the expansionary effect of net domestic assets (NDA) on broad money supply was moderately offset by net contraction in foreign assets of the banking sector.

As per the press release, net foreign assets recorded a fall of Rs793 billion translating to a negative effect of 5.4 percentage points on broad money growth in FY18.

Due to this, broad money supply showed a net expansion during FY18 against 13.7 percent in FY17.

Going forward the opposing direction of NFA from its NDA counterpart can keep broad money growth low in FY19, said SBP.

Furthermore, the current account deficit rose 1.4 times compared to same period last year during FY18, touching $16 billion in first 11 eleven months, said SBP.

It said the large increase in imports offset the strong recovery in exports which rose 13.2 percent on a YoY basis during July-May FY18 and rise in worker remittances (3 percent in July-May FY18).

SBP said imports ratcheted up due to demand for productive imports ((metal, transport, machinery and petroleum) and a sharp rise in global oil prices widened the current account deficit to levels not viable beyond the short-term.

Due to a lack of matching financial flows, a major share of the higher current account deficit ended up being financed by using the country’s own resources, said the central bank.

However, the bulging current account deficit affected the central bank’s foreign exchange reserves which experienced a net reduction of $6.7 billion to touch $9.5 billion as of July 6^th, 2018.

The central bank highlighted “these developments suggest that the near-term management of the country’s external accounts is of critical importance.”

After detailed deliberation, the monetary policy committee (MPC) observed the following factors were adding to the growing economic challenges which include “the multiplier-effect of a strong fiscal expansion during the second half of FY18 is likely to offset the contractionary impact of monetary tightening in the recent months on domestic demand, higher international oil prices have continued to inflate the import bill; rising inflation projections and the ensuing fall in real interest rates; and a notable reduction in PKR and US interest rate differential,” said the central bank.