The central bank has demonstrated flexibility by adapting its policy framework to include significant structural changes recommended by the International Monetary Fund (IMF) in the Monetary Policy for the first half of the fiscal year 2024. In our macroeconomic report titled “Navigating Rough Tides Ahead,” published on June 16, 2023, we outlined two potential policy responses that the central bank could adopt: an “Aggressive Response” and a “Progressive Response.” It appears that the central bank has chosen the progressive response, as outlined in our report, by hiking the policy rate by 50 bps along with an indication of the continuation of debt monetization which is consistent with that approach. However, CAL anticipates the progressive response might not be sufficient to anchor the macro variables.

CAL’s view on the policy measures:
Embracing Tighter Monetary Conditions:

The adaptation of a contractionary monetary policy stance is a notable step towards achieving macroeconomic stability. The tightening of monetary conditions is expected to discourage unproductive financial flows and mitigate demand-side concerns to some extent. However, it is evident that the central bank is exercising caution to avoid overly rapid rate increases, as this could potentially impede economic growth and contribute to the accumulation of non-performing loans (NPLs) in the banking sector. Nevertheless, the success of this contractionary policy stance hinges on its effective implementation.

The Adoption of SMART:

The introduction of the market-driven reference lending rate, known as SMART, is expected to result in lending rates surpassing the 10% mark. While this move will increase the cost of borrowing, it is also anticipated to alleviate some inflationary pressure. However, the calculation method based on a six-month moving average rate of treasury bill will introduce a certain time lag in effectively incorporating real-time market dynamics into lending rates.

Implementation of Unified Exchange Rate:

The implementation of a market-driven single exchange rate regime from July 2023 is expected to facilitate the establishment of an equilibrium price for the currency. This adjustment will help smooth the supply of USD for trade settlements, enhancing stability in foreign exchange transactions. However, it is important to consider that achieving currency stability, in conjunction with the normalization of external trade, will depend on the timeframe for adopting the Unified Exchange Rate and its effective implementation.

Domestic and Foreign Asset Growth Projections:

The policy steps outlined above are crucial for restoring macroeconomic stability. However, two significant factors will greatly influence the implementation of these policies by December 2023. Firstly, the notable 16.8% growth in domestic assets forecasted in the MPS indicates that the central bank is likely to rely on debt monetization to finance the budget deficit. Secondly, the substantial 20.3% forecasted decline in foreign assets suggests that the central bank may continue to sell reserves until December in order to provide support for the currency.

While the current MPS policy response leans towards the progressive response, the indication of continued sales of USD by the central bank will add a new dimension to it. If the central bank persists in selling USD until December, a reduction in the forex reserve may raise additional challenges in meeting the IMF’s Quantitative Performance Criteria (QPC) for December 2023.