* Former IMF negotiator advocates rate rise
* Sees rupee fluctuating around 80 per dollar
* Expects growth of 2 percent, marking recession
By Sahar Ahmed
KARACHI, January 22 (Reuters) - Pakistan needs to hike interest rates further to build foreign exchange reserves and dampen inflation despite facing recession, according to the economist who led IMF negotiations with Pakistan two months ago.
Mohsin Khan retired as director of the IMF's Middle East and Central Asia Department at the end of November immediately after concluding the $7.6 billion emergency stand-by credit agreement to rescue Pakistan from a balance of payments crisis and looming default on its international debt.
Pakistan entered a 23-month standby credit facility to correct external and fiscal imbalances, bring down inflation running over 25 percent and alleviate poverty.
The first tranche of $3.1 billion credit was released on Nov. 26. The next tranche of $850 million is due to be released subject to an IMF review that should be completed by March 15.
The government should meet its first review targets, as it has largely set the targets itself, though achieving zero net government borrowing from the central bank will be difficult.
The central bank ramped up interest rates by 2 percentage points to 15 percent in November, and many analysts in Pakistan believe interest rates should be reduced quickly because of an alarming economic slowdown.
The central bank has forecast growth slowing to 3.5 percent to 4.5 percent in the 2008/09 fiscal year ending June 30, its weakest pace since 2001/02.
Now a senior fellow at the Peterson Institute for International Economics in Washington, Khan gave his views on the outlook for Pakistan in an email response to questions ahead of the State Bank of Pakistan's half year monetary policy review, due to be announced on Jan. 31.
The following is a transcript of Khan's answers:
Q: Do you expect an increase in interest rates, given inflation has begun moderating and the trade deficit has started to narrow?
A: The case for raising interest rates further is that core inflation is still too high, so you can't blame inflation on energy (oil) and food prices, both of which have come down quite sharply in the last few months. Therefore, based on the core inflation numbers, another 100-150 basis points would seem to make sense. This is an orthodox prescription. However, the monetary tightening already done in November (raising the rediscount rate by 200 basis points to 15 percent), and any further tightening to come will not have a significant impact on inflation (headline and/or core) for a while. So one should not expect too much from higher interest rates on inflation in the next few months. But, I think there is a stronger case to raise interest rates, which is to strengthen the international reserves position of the State Bank of Pakistan. For some reason this point has not been stressed as much as it should have -- the focus has been too much on the monetary policy-inflation link. The effect of interest rates on international reserves can be quite quick (and certainly much quicker than the effect on inflation). The usual channel is capital inflows, but in Pakistan remittances are also influenced by interest rates (and the exchange rate). See how remittances jumped after the increase in interest rates in November. With a relatively stable exchange rate (around 80 rupees per dollar), Pakistani interest rates should be quite attractive, particularly for overseas Pakistanis.
Q: How do you see Pakistan's economy faring?
A: With the world in recession, I don't expect the Pakistan economy to grow by more than 2 percent or so this fiscal year. And this too depends on how agriculture does. For Pakistan a 2 percent growth of real GDP is a recession. Moreover, it's difficult to see where higher growth in 2009-2010 is going to come from with the world recession worsening. Lower oil prices are a mixed blessing for Pakistan. Yes, import costs are lower, but the demand for Pakistani labour in the Gulf and foreign direct investment from the Gulf are also lower.
Q: What is your outlook for the rupee?
A: I think the rupee will fluctuate around 80 per dollar. Barring any other external shock, the worst is behind the country. If remittances do as well as they are doing, and there are some capital inflows, State Bank of Pakistan's international reserves and the amount of dollars in the open market should increase. This may actually lead to pressures for the rupee to appreciate against the dollar, i.e., become stronger. My own view is that the rate is about right and that the SBP should, if needed, buy dollars to keep it there (and add to its international reserves). It is always better for a country to have an undervalued exchange rate than an overvalued one. (Editing by Simon Cameron-Moore)