Although there is a strict prohibition against charging interest, a significant number of Islamic banks still rely on interest-based benchmarks like Karachi Interbank Offered Rate (KIBOR) or London Interbank Offered Rates (LIBOR) as a way to determine profit rates. This is partly because of the lack of stable and widely-available alternatives. There are several elements that can influence the rates of KIBOR, Treasury Bills & Bonds, including domestic interest rates and predictions about future changes in the interest rates. KIBOR is commonly employed as a benchmark for determining the profit rates on various Islamic finance products such as Musharaka, Mudaraba, and Murahaba. It is also used as a reference point for pricing Government Ijarah and Corporate Sukuk.
A significant event is planned for the coming week, during which the State Bank of Pakistan (SBP) will unveil its first monetary policy of the year on January 23, 2023. Most analysts and brokerage houses expect SBP to continue with monetary tightening and increase the policy rate and discount rate by 100 bps to 17% and 18% respectively, on the back of rising inflation and weakening foreign exchange reserves.
In a surprise move, the Central Bank’s Monetary Policy Committee (MPC) hiked the policy rate in the last monetary policy statement (November 2022) by 100 bps to 16% with a majority vote of 7 out of 9 members. Cumulatively, the policy rate has increased by 225 bps during the first half of FY23 and 900 bps since the end of the monetary easing cycle on September 2021. The policy rate of 16% is the highest level since FY98, even higher than the peak of 15% during the FY08-09 crisis.
Table 1: Monetary policy statement trend
|MPS dates||Policy rate||Change|
|Trend in FY23|
Source: State Bank of Pakistan
Inflation around the world remains high, largely attributed to the strength of global recovery post-pandemic and supply-side disruptions due to the Russia-Ukraine conflict, which has taken global commodities prices to new highs across both the developed and developing countries. A stronger US dollar arising from aggressive rate hikes by the FED (a rise of 275 bps during the first half of FY23 – the highest it has been in the past fifteen years) is also adding inflationary pressures and fueling higher energy costs.
In Pakistan, in addition to the unprecedented levels of petroleum prices, the inflationary outlook was deepened by the sharp increase in electricity tariff – to comply with IMF conditions for program resumption – and, more recently, disrupted food supplies due to the floods. Since the last monetary policy statement, macro-indicators are not shaping well broadly, consumer price index numbers rose by 24.5% YoY in December, compared to 23.8% witnessed in the preceding month of November. Core inflation for the month of December also stood high at 16.4%.
Overall 1HFY23 inflation is up 25% and expected to exceed SBP’s revised forecast of 21-23% for FY23. Meanwhile, the Sensitive Price Indicator (SPI)-based inflation in the week ended the 12th January recorded an increase of 0.44% due to an upsurge in prices of food items.
Due to more stringent administrative controls, Current Account Deficit (CAD) continued to moderate, reaching US$0.3 billion in November 2022, the lowest level since April 2021. CAD shrank by 57% during 5MFY23, mainly due to lower goods import bills with CAD of US$3.1 billion. While exports remained flat, declining by only 2% YoY to US$12.1 billion, imports declined more sharply by 16% YoY to US$24.9 billion.
Key reasons for the contraction were significantly slower economic activity and substantial rupee devaluation, but the restriction on non-essential imports also helped to contract the trade deficit to US$12.8 billion, down 26% YoY from US$17.4 billion during the same period last year.
Despite this moderation and fresh commitments from the donor agencies & friendly countries, external account challenges are growing as foreign exchange reserves of the SBP decreased to the lowest level in decades. Dwindling foreign currency reserves remain the biggest concern for the country, Pakistan’s foreign exchange reserves were down by US$3.1 billion to US$4.3 billion on the 6th January 2023 from US$7.4 billion on the 25th November – since the last monetary policy statement; the level was equivalent to less than four weeks’ import cover due to debt repayments and stoppage in foreign inflows.
Worker remittances declined by 11% YoY to US$14.1 billion during 1HFY23 as the difference between the open market & interbank exchange rate widened, leading to greater inflows through informal channels. Amid dwindling foreign exchange reserves, political uncertainty, and recent floods, the Rupee depreciated by 11.4% to date* against USD since June 2022 in the interbank to PKR228.15/USD.
Table 1: Summary of the change in market yields since the last monetary policy announcement
|Description||Latest yields||Yields at Last MPS announcement||Change|
|16th January||25th November|
|KIBOR 3 Months||17.07%||15.87%||1.20%|
|KIBOR 6 Months||17.11%||15.90%||1.21%|
|KIBOR 12 Months||17.38%||16.19%||1.19%|
|T-Bill 3 Months||16.98%||15.78%||1.20%|
|T-Bill 6 Months||17.02%||15.79%||1.23%|
|T-Bill 12 Months||17.03%||15.80%||1.23%|
|PIB 3 Year||16.24%||14.22%||2.02%|
|PIB 5 Year||15.16%||13.29%||1.87%|
|PIB 10 Year||13.94%||12.93%||1.01%|
|US$ Inter Bank||228.34||223.94||4.40|
|US$ Open Market||238.75||231.00||7.75|
Source: State Bank of Pakistan and Mutual Fund association of Pakistan
Regardless of massive liquidity injections by SBP via Open Market Operations (OMO), short-term yields inched up more than 120 bps compared to the last monetary policy statement announcement. Similarly, long-term yields also adjusted upward sharply by (approx.) 200 bps indicating the market is expecting further rate hikes in FY23. Since the 18th November 2022 till date*, SBP has injected a massive amount of PKR6.3 trillion into the money market via OMO injection. In the current scenario, managing yields with OMO injections are not the solution; it is a debt trap and a never-ending cycle.
On the fiscal side, it will be a challenge for Federal Board of Revenue to meet its revenue target for the year due to weakening demand, import shrinkages, and supply disruptions. Recent floods will make it more challenging for the country to achieve aggressive fiscal consolidation.
Maintaining a balance between the fiscal and monetary policy is the key to combating higher inflation and helping to reduce external vulnerabilities. The IMF has been adamant that it wants Pakistan to remove subsidies on energy prices and levy additional revenue measures for the restoration of the program through increasing gas prices and imposing petrol development levy on petroleum products.
However, all these actions will lead to further inflation in the future. It will be interesting to see how the current Prime Minister, Shehbaz Shareef, will deal with the difficult economic decisions ahead of the election year.
Faizan Saleem is the senior vice president, head of Shariah Compliant Income Portfolios at Al-Meezan Investments. He can be contacted firstname.lastname@example.org.