The shift towards monetary tightening, evident elsewhere in Asia for several months now, has finally reached

Pakistan. The State Bank of Pakistan (SBP), the country's central bank, announced a 50-basis-point interest rate hike
on Friday (30 July). The discount rate was raised to 13%, thus ending seven-months of "on hold" policy stance during
which the SBP focused on consolidating the recovery. The move does not come as a surprise since underlying
macroeconomic preconditions for an eventual monetary tightening have been gradually building throughout the year.
The only question was that of timing of the first rate hike. In fact, IHS Global Insight's forecast had for a long time
incorporated a 50-basis-point rate hike in July; it was only the easing in inflation during June that had led us to move
the start of tightening to September. In the event, the central bank appears to have taken heart from the quickened
pace of tightening elsewhere in the region and decided to not wait any longer.

Fragile Economic Recovery Responsible for Delayed Tightening

Following three aggressive interest rate cuts during March-November 2009, totalling 250 basis points, the SBP faced
a policy dilemma. On the one hand, economic performance had remained sluggish. Heavily undermined by external
demand shocks associated with the global recession and exacerbated by Pakistan's own balance-of-payments crisis,
the economy showed little response to the previous monetary stimuli and required additional support. Indeed, real
GDP expanded a mere 1.2% in annual terms in fiscal year (FY) 2009 (July 2008-June 2009) after an average of 6.6%
annually during the previous five years. Moreover, the first half of FY 2010 did not look promising either. On the other
hand, however, the bank was facing resurgence in inflation. Upward price pressures were magnified by energy price
adjustments in January 2010 in line with International Monetary Fund (IMF) requirements (see Pakistan: 11
February 2010: Inflation in Pakistan Rises Further on Higher Domestic Energy Prices). These inflationary
concerns called for a more hawkish approach to monetary policy.

Fiscal management also became increasingly challenging, adding further pressure to both real growth and the overall
macroeconomic stability. Unforeseen increases in defence and relief expenditures amid the government's offensive
against the Taliban diverted resources away from public investment into financing of military operations. As a result,
in FY 2010 public investment's share of GDP declined for the first time in seven years. Private investment was also
circumscribed, crowding out effects of high domestic borrowing by the government. Concurrently, increased
government borrowing from domestic sources to finance the gap between rising expenditure on one hand, and low
revenue collection and delayed external financing on the other hand led to a substantial increase in net domestic
assets of the banking system. The borrowing targets from the central bank were breached in both the third and fourth
quarter of FY 2010, fuelling liquidity growth and stoking already high inflationary pressures.

Rapidly Intensifying Pressures Leave No Choice for Central Bank

Provisional figures for the FY 2010 fiscal deficit marked a turning point in the SBP's monetary stance. With
provisional tax collection numbers coming almost 4% short of original targets, the revised fiscal deficit target of 5.1%
has been certainly missed; we estimate the shortfall at more than 6% instead. Net government borrowing from the
central bank in the second half of the fiscal year also exceeded the target by 3.5%, indicating a further increase in the
net domestic assets and money supply. Such developments aggravate the risks to macroeconomic stability and
contribute to higher inflation expectations. The FY 2011 fiscal outlook does not look much more optimistic.

The new fiscal deficit target of 4% of GDP remains a rather unrealistic target since it would imply a 25.6% increase in
tax revenue, or about 0.8% increase in the tax-to-GDP ratio. Even given the successful implementation of the Value-
Added Tax (VAT) reform, more aggressive measures to broaden the tax base will be required to achieve the target
(see Pakistan: 18 June 2010: Budget 2010/11: Pakistan Looks to Cut Deficit with Ambitious Tax Revenue
Targets). These developments build on top of already existing negative inflationary trends. While a slight recovery in
growth suggests an uptick in domestic demand, the aggregate supply is not likely to improve in the near term owing
to persistent energy shortages and a rampant security situation. Moreover, an implementation of a series of policy
measures, planned during the current fiscal year, will further increase inflationary pressures. The introduction of the
value-added tax—a critical condition of the IMF macroeconomic stabilisation programme and a crucial measure to
boost revenue collection—is planned in October 2010. In addition, the second electricity tariff hike, originally planned
for April 2010, has been also delayed for the second half of the year, and the effect of it is still to be reflected in the
forthcoming inflationary trends. Given the balance of all forces, further delay for the monetary tightening would be an
unjustified risk to the macroeconomic stability that Pakistan's fragile economy is not ready to undertake.

Outlook and Implications

Considering the latest macroeconomic developments in Pakistan, IHS Global Insight expects at least another rate
increase of a smaller or similar magnitude between now and the end of the year. Remaining monetary policy
meetings are to be held in September and November. With expected further recovery in domestic demand,
adjustments in the energy prices and continued volatility in food prices, the headline inflation is likely to remain in
double digits until the end of the calendar year 2010. We currently expect the annualised CPI inflation to reach 11.8%
in 2010, and the risks are on the upside.

Adjustments in the monetary policy as well as the new challenges to the macroeconomic outlook will clearly be
reflected in our new outlook for the broader economy. The central bank is aiming for growth of 4.5% in FY 2011.
However, tighter monetary conditions and the austerity measures required to sustain the fiscal deficit within targeted
limits could herald a considerable slowdown in economic activity, undermining recent positive gains in manufacturing
production, domestic demand and external trade profile. Moreover, the uncertain political and security environments
also pose additional risks to the growth outlook in the near future.