The jury is divided on the impact of PKR depreciation

Tariq Bajwa took charge as the Governor SBP in July 2017. Mr. Bajwa is a career civil servant by profession, having varied experience including the Head of Pakistan’s Trade Mission in Los Angeles; Secretary Finance, Punjab; Chairman FBR; and Federal Secretary Finance & EAD. In this interview, BR Research takes his views on the external account including trade, remittances and FDI; SME and housing finance; and rupee depreciation.   Below are edited transcripts.

BR Research: The external side is in severe imbalance. There is a hypothesis that if import cover falls under two months, we go back to the IMF, and that could affect Pakistan’s stabilisation and economic growth. What is the SBP doing to manage those risks?

Tariq Bajwa: The twin objectives of SBP are monetary stability and growth. Our growth is going well but the pressure on current account is challenging, which can hamper stability. The strategy is a coordinated yet an innovative policy mix. If you look closely, the policy mix has been about balancing the trade and financial channels while the administrative measures have not been spared.

To that effect, there is a coordinated effort including: cash margins, regulatory-duties, external borrowing through Sukuk and the Euro bond issue, market-led rupee depreciation, and to some extent, a forward-looking increase in interest rates by the independent monetary policy committee to essentially arrest excess demand until the supply side is in full swing.  These measures are expected to help the economy grow at a pace that is compatible with the expected behaviour of the supply side.

Inflation is slightly inching up. The numbers for January are in line with our expectations for FY18, but monetary policy decisions are envisioned with a lag of two to four quarters and for a medium-term horizon. Otherwise, the broad numbers of growth are doing well. Last year, we had the highest growth in ten years, and this year it is highly likely that we will beat last year’s number. Indeed, all indicators suggest that we would be able to reach 5.8 percent growth. But, it is not just about reaching ever higher growth rates; it is also about how sustainable the growth is going to be.

So far, large scale manufacturing numbers continue to be good despite the aberration in November. The crushing of sugar hadn’t started back then, and there was the issue related to furnace oil as well, as refineries were closed down. With the refineries back on track, and sugar crushing started, we expect the LSM growth close to the target of 6.3 percent for FY18.  In fact, if you closely look at the data, LSM does not have to perform spectacularly in the remaining few months of FY18 to satisfy the target.

BRR: How worrisome is the surge in current account deficit and how could Pakistan come out of the trap?

TB: The elephant in the room is the current account deficit, and it might fall in the range of 4.5-5.0 percent of GDP in FY18 – i.e. higher than last year. For the last three years, our exports had gone down. For example, we were exporting around $25 billion in FY14, while we only managed $21.9 billion in the last fiscal year; so that has been a setback. There were global headwinds and that also had an impact on Pakistan’s share in global trade, but we were probably losing more than others. We must win back these contracts.

At the same time, imports kept on increasing and the balance of trade became more skewed than ever. The gap was always met by remittances, which were growing at around 13.7 percent, on average, for the last ten years. However, we took a hit last year as remittances went down by 2.8 percent year-on-year.

The above picture is changing though. Indeed, what has changed this year is that our exports have started growing and it is spread across sectors. Remittances have also increased by 3.5 percent during the first seven months of FY18 over the same period of last year.

At a more general level, when it comes to worries about the current account deficit, commentators often compare 2018 with 2008 and especially 2013. These are in fact different situations.  In particular, 2013 was more of managing a higher external debt servicing situation, while 2008 was a massive oil price shock. Unlike in the past, we are in the middle of a large investment program with important geopolitical implications.

Therefore, the policy mix has to recognize this difference as well as the challenges.  You cannot let your past policy mistakes crowd out your future policy thinking.  Therefore, policy innovation in a forward-looking manner is needed and that’s what has been implemented. Corrective measures are in play and exports are picking up while remittances are stabilising.

BRR: What has changed on the remittances side of the story?

 TB: Last year, almost 60 percent of our remittances came from the Gulf countries, and more than one-fourth from Saudi Arabia. Saudi Arabia is going through its own challenges and not only the economy was slowing down, there was also a change in their labour policy – replacing expatriate labour with locals – amid a host of fiscal reforms.

As a result, the number for labourers migrating to Saudi Arabia has decreased. We have around 2 million people in Saudi Arabia and some of them are coming back. We unfortunately, don’t have the numbers for individuals returning, but we have the numbers for people leaving from here.

We are facing similar issues in the UAE. The numbers for Dubai are more or less the same. Qatar was marginally higher, but they are in small numbers. Secondly, the depreciation in pound, euro, vis-à-vis the dollar last year, also impacted our numbers. Thirdly, developed countries became more intrusive and came up with new regulations and migrants are always shy of being found on the wrong side of the law.

BRR: Let’s talk about the two factors in remittances. One is the oil at $70 a barrel and the other is currency appreciation. As you mentioned that we will see some growth, but it does not seem to have the legs to make it double digit.  For that, we have to be innovative. What will be that innovation?

 TB: We are doing two things for innovation. Most of the Pakistani labour in UAE is unaware that there are no charges for sending money home and that the government is picking up those charges. Clearly, the incentives are there, but these also need to be communicated effectively to the masses.

We have started marketing campaigns to fill this massive communication gap. We have also engaged banks and have asked them to go to these labour camps and interact with them. We have placed TV screens with repeat messages in consular office in Riyadh, and we are setting up similar facilities in Jeddah, Dubai and Abu Dhabi.

The other part is that the challenge we have to compete with the hawala and hundi. According to our estimate, a significant part is still coming through informal channels, and that is the low hanging fruit we want to pluck. We have to compete with them both on efficiency and cost, to be able to divert a substantial part to the formal channel.

For that, we have launched a new program under which one can use a mobile wallet to receive home remittances. We are done with all the regulations needed and the program has been launched. Now we are in its marketing phase, so efficiency will be attained. On the cost front, we can’t have differential exchange rates but to give an incentive, the government with telecom firms will be contributing Re1 of airtime for every dollar received via mobile wallet. If we are successful in marketing this program properly along with the banks, this can be a game changer.

BRR: Out of the $18-20 billion of remittances, what percent is used for consumption and what is the share of investment?  How much investment are the expatriates willing to do in Pakistan and how can they save money in terms of bond issues?

TB: It is difficult to provide accurate break-up of the uses of remittances due to large variations in different studies. However, it is certain that low income families generally spend more than half of their remittances on personal expenditures. The other common uses of remittances are real estate, agricultural machinery, loan repayments etc. Further, most of the remittances are sent in small amounts. So it is estimated that almost 90 percent of the transaction volume is aimed at consumption purposes. Financial savings are nonetheless low amongst remittance recipient households.

BRR: HBL had recently cut its ties with Al Rajhi Bank. What is the impact of that on the remittances and whether the banking community has reestablished their ties with them?

TB: It should be remembered that we have non-exclusive business model for remittances, which means domestic banks can enter into correspondent relationship with overseas financial institutions. This policy provides natural shock absorbing ability in such incidents as discontinuation of HBL and Al Rajhi relationship. Since other domestic banks already had business relationships with other banks, we were quickly able to stabilize the situation.

Further, we had sent a high-level team that had meetings with the Saudi Arabia Monetary Authority, and they will also facilitate smooth flow of remittances to Pakistan.

There is one more facet about remittances. Saudi Arabia has imposed a tax on all migrant dependents, which will be increasing in coming years.  Due to this cost, anecdotal evidence suggests that thousands of Pakistanis are sending their family members back.  This may increase remittances in the coming months.

Going forward, there are two factors affecting remittances. One is the oil price going up and the second is mobile wallet. We are expecting remittances to grow by 3.5-4 percent for this year, reaching $20 billion.

BRR: Let us talk about exports. How much of an impact can rupee depreciation make to the bigger picture?

 TB: As far as export is concerned, there has been some growth. The reasons are the policy measures undertaken by the government and the overall global environment. Recent depreciation of the Rupee may also help us in the near future. We won’t see an immediate impact, but it would be visible in coming months.

Nevertheless, the jury is divided on the impact of currency depreciation. It all depends on where you are on the J curve.  It also depends on whether you have exportable surplus or not. To me, there is exportable surplus in Pakistan as of today. I’m saying this because we had been exporting goods worth $25 billion four years back.

So we do have that capacity, and it should not be an issue raising it to say $30 billion, and in that, depreciation can help.

BRR: Pakistan’s currency against euro and pound has depreciated by 10 percent. So there is a double impact on depreciation. Do you think that is good enough or we need more depreciation?

TB: It is a very decent number, but I would say let the market decide that.

BRR: You talked about Pakistan having enough export surplus capacity. What is your take on exploring new market avenues?

 TB: We are doing it. I have been a trade officer also. The task for a trade officer is to create a conducive environment and that is what the trade policy has to do as well. The new policy says that if you go into a new market, you’ll be given additional two percent, which is a really good incentive. Going to new markets and diversification of products is not easy but over a period of time there has been some diversification.

For instance, a new diversified market for ‘kinnow’ has been seen from Russia to Indonesia. Potatoes are one potential market in Russia. The greatest potential is in African market but the issue is that they take deferred payments and enforcement of contracts is not as good as one would get, say, in EU countries, so entrepreneurs are scared doing business there. So the potential is there, but it is going to be an uphill task to take advantage of these opportunities.

BRR: So the focus then is turned to the agriculture sector?

 TB: Yes, to a large extent. We claim to be an agricultural country, but it is a shame to see that even our food imports are rapidly increasing. We import about $800-900 million of key vegetables every year.

BRR: The latest inflation numbers show a 10 percent monthly decline in perishable food prices. Fluctuation in prices because of the supply chain issues has been a long standing problem. What is the SBP doing to address the issue?

 TB: We are working on the value chain financing as well as financing for creation of silos to smooth out commodity supply. There is also an SME policy and this is one of the pillars of the SME policy. We have identified a few SME sectors, and food and vegetable processing are also in that list. We are going to provide them loans at maximum 6 percent. The SBP will provide subsidised capital to banks at 2 percent and the maximum they can charge is 4 percent.

BRR: Are you looking for areas other than traditional textile and other manufacturing. Our traditional markets now have Vietnam and other countries. How are we dealing with that?

 TB: For the five export oriented sectors, we have a long term financing facility to set up industries, where we are charging only 6 percent and this has been going on and there is a large off take of credit in this sector.

Secondly, the SBP Board has approved the use of Islamic instruments for long term financing facility. Thirdly, we have another export-financing scheme where we give short term working capital at a subsidised rate.

The other part is that we need to be more consistent as far as Latin America is concerned. We have been opening and closing down trade offices every now and then. It takes about 1-2 years to settle down and develop contacts. Then the trade officer has to get concessions from the host country and help create business-to-business contacts. All of it requires support from the government and the private sector.

In the software industry, for instance, the government is consistently trying to improve its policies. This year, they were given tax breaks in the budget and they were allowed to open foreign currency accounts. We should have IT exports worth of $4-5 billion, if we continue to create an enabling environment.

BRR: Let’s talk about imports. For imports, we have to talk about import substitution. A reverse of import substitution took place in ten years as a result of which our imports grew. So the first way to deal with this is to improve import substitution. Is the SBP working on this?

 TB: I think we need a very deep analysis on the FTAs that we have done and how have they impacted our economy. Have they positively or adversely impacted an industry particularly? My own assessment is that they haven’t helped us much. Many of our industries did close down because of this. We have to make our imports more expensive. Otherwise, it would be hard to compete with our local industry.

For that the government has imposed a regulatory duty on luxury goods. Then we have imposed a provision of 100 percent cash margin and the depreciation will make the goods more expensive. We are already witnessing a deceleration in the growth of imports. It was over 20 percent and now is in single digits (December 2017).

BRR: The element of import substitution is very closely linked to the SME as well. For instance, the light engineering sector has so much of influx of goods from China. What could be done to address the issue?

TB: We have tried to identify all obstacles for SME financing and then address them, in the new package. We are not only talking about availability of finances at affordable rates; we are also talking about educating both the banker and the entrepreneur. We are also talking about the non-financial advisory services where the banker must do some handholding. We have simplified and unified documentation for loans, bringing it to a couple of pages from 5 to 6 pages.

We are also talking about incentivising banks to lend to the SMEs, as share of SME financing in private sector credit has come down to 8.8 percent from 17 percent. Our target is to take it back to that 17 percent.

BRR: When you suggested financing of SMEs, interest rates were low. Now the interest rate cycle is going up. Will that be an issue?

TB: That should not be an issue because on SBP refinance schemes, the rates are fixed not floating.

BRR: Back to imports. We have three elements in import: energy, expansion, and consumption. Now for energy, if you want to decrease imports over the period, you need indigenous fuel sources, but the pace on that front is very slow. Is there any long term focus on this front?

 TB: In the long term, we have to focus on the renewable energy sources since they bear no import cost in the long run. The issue is that solar energy has no effect on the base load. Unless storage becomes inexpensive, this could happen in the next 2 to 3 years. However, the cost of solar energy is going down. Similarly, the cost of wind energy is going down. Wind has no dependency on the baseload. There are a lot of people willing to invest in this corridor.

BRR: But it is a very small part of the total component.

TB: I don’t disagree with you, but our way forward in the long run is to switch to solar energy, provided the storage capacity and cost are good.

BRR: What is the SBP doing about it?

TB: We have launched a scheme for renewable energy sources (up to 50 megawatts) where we are giving them subsidised credits at fixed rate of 6 percent. Our work is to facilitate the financing of such tasks.

BRR: What is the purpose of tightening of the monetary policy? We already have controlled inflation.

TB: The argument in the monetary policy committee was that the decisions taken in monetary policy have a lag time varying from two to four to even six quarters. In other words, the committee took a forward-looking policy action and in the interest of safeguarding future stability.

We mentioned this in our statement that as far as this year is concerned, 6 percent inflation target wouldn’t be breached. However, in FY19, oil prices are expected at around $70 per barrel and equally important that there are all indications of an expected positive output-gap, that is demand beginning to outstrip supply, therefore, we had to take this corrective measure in advance, keeping FY19 in mind.

BRR: Consumer confidence has lately seen a drop. Do you think it is a leading indicator or a lagging one?

TB: I think it is partly a lagging indicator, since it captures the prevailing economic conditions. But at the same time it also covers future expectations. So its movement is influenced by both, depending which part is causing relatively more variations.

 BRR: Let us move on to FDI. Today, we have an FDI of $3-4 billion despite such high guaranteed returns in power sector. Why can’t we attract more high quality and diversified FDI?

 TB: There is diversification in sectors other than power, such as food. Significant FDI is coming in the automobile sector. There are 3 to 4 other companies in the queue to come to Pakistan. If you look at all these FMCGs, they are into expansionary phase. We have investment coming in for aluminum cans, steel, diapers and so on.

 BRR: How precarious is Pakistan’s position in terms of debt financing, given the level of current account deficit, and the debt repayments coming up?

TB: You have to understand our dealings with the IFIs. Pakistan receives project and program loans from World Bank group and Asian Development Bank under the country partnership strategy. These loans are generally concessional and long term in nature. We also get loans from the Islamic Development Bank and Asia infrastructure International Bank.

Then the government goes to the commercial banks and borrows. Then there is the capital market avenue as well. Pakistan has recently mobilised US$ 2.5 billion by issuance of Sukuk and Eurobond.  So as a combination, we would try to manage the deficit.

At the moment there aren’t any alarm bells ringing about us asking for help from the IMF. There isn’t anything wrong in asking for help from the IMF, but you approach the IMF only when you think you are suffering from some malaise. Why should we do that? Why should we not take corrective measures ourselves before reaching that point?  And this is what I mean when I say an innovative policy mix.

BRR: So you are comfortable with the fact that if the oil prices don’t go up, we aren’t heading to the IMF in 2018?

 TB: This is primarily the government’s decision, but as I said earlier I don’t see it at this point in time.

BRR: You talked about regulatory duty and cash margin. The IMF takes this with a pinch of salt, as it believes it causes distortion.

TB: They have talked to us about cash margins but they have no issue with RDs. We are a member of the WTO and the trade is being regulated by WTO. And in WTO there are two types of tariffs; one is a bound tariff and the other is an applied tariff. Bound tariff is when you inform about all the 7000 items to the Pakistan Custom Tariff Court, that this is the maximum level we can have. Applied tariff is the one you use today. The laws throughout the world permit us to take applied tariffs to bound tariffs whether we impose RD or permanent duty, that’s our call. So it is absolutely legal under all our international commitments.

 BRR: Take us through the modalities, modes, and limits on trading in yuan?

TB: The regulatory framework in Pakistan allows the use of CNY in trade and investment transactions, such as opening of L/Cs and availing financing facilities in CNY. In terms of these regulations, CNY is at par with other major approved currencies. Moreover, the CNY denominated trade and investment transactions can also be facilitated under the current currency swap arrangement between China and Pakistan.

We need to implement an effective communication strategy and due to our press statement, there was a stir in the market and people started talking about it. You are right that this has been in the market for 2-3 years but there haven’t been too many takers. The statement we made has suddenly created awareness about this.

Now the next step is to create or facilitate the first few transactions and to do that, we have called the banks. There is a great deal of interest that is being generated.

BRR: Do you plan to have Yuan as a reserve?

 TB: It is an already authorized currency, and is even included in the basket of currency by the IMF. But still all our values are denominated in dollars.

BRR: Why don’t you impose an upper SLR limit on banks?

TB: What you are saying is right but we undertake two measures. The first one is ADR, which we are trying to increase at the moment. Another thing is that last year, our credit off take to private sector has seen a good growth. They are moving in the right direction.

BRR: At one point in time, the limit for SLR was there in the monetary policy. Do you think it will be included in the next two years?

 TB: It was there but with the passage of time, the SBP has moved to purely market based implementation of monetary policy. That is why we are choosing interest rates to signal our monetary policy.

BRR: Recently we have signed MoU with a Russian bank, which is the 20th such in last one or two years. What is that all about?

TB: It is all about starting to develop banking relations between Pakistan and Russia. Currently there is no Pakistani bank in Russia and no Russian bank in Pakistan. We only have correspondence relations through National Bank of Pakistan. The discussion we had with the Governor of the central bank in Russia was about creating an enabling environment for trade. The broad objective of MoU is to start developing banking relations between Pakistan and Russia and enhancing collaboration between the two central banks for learning and gaining benefits from each other’s banking system experience.

BRR: Tell us about your initiatives on agriculture, housing and SMEs?

 TB: We have shared our entire policy in SME financing. It’s a bold step taken by the central bank, and we have identified all the impediments to SME financing and tried to address each and every one of it in our policy.

By the next month, we will be coming up with a financing policy for low cost housing. We have three priority areas of agriculture, SME and low cost housing, and we are convinced that these three areas can directly contribute to growth.

Agriculture is a no brainier as 40 percent of our population is directly related to it, and the best part of it is that it has the shortest turnover period. You are talking about 90 days to 120 days for a crop cycle. We are concentrating on dairy and livestock, and we are pushing for production loans.

Secondly, about 40 percent for all your business units are from the SME sector. And unless you have a very strong SME sector, you can’t build a strong industrial sector. So you need a strong SME sector.

And third is the low cost housing. There is a shortage of about 10 million housing units and that number is adding on every year; and on top of that, real estate and buying and selling of plots has blocked trillions of rupees in a completely unproductive sector. This is a Dutch disease we are suffering from. For that, you must encourage construction.

BRR: Will you opt for builder financing or mortgage for the low cost housing?

TB: We are working on mortgage financing and long-term mortgage at decent rates to be made possible and that is the challenge. The idea is to reshape the banking sector so that lending over the long term can be made possible.  This will require a coordinated effort from the credit side and also from contract enforcement authorities.