Time for difficult decisions

It was expected that tightening of the monetary policy by the State Bank of Pakistan during 2004-05, as indicated by successive increases in T-bill yields, raise in discount rate and an upward trend in lending rates of the commercial banks, would slow down the rate of monetary expansion which, in due course of time, would have a softening impact on prices.
These expectations, as the latest data show, do not seem to have materialised. Although money supply upto June 25, 2005 in percentage terms recorded a smaller increase of 17 percent as compared to 19.6 percent during 2003-04, the overall expansion in liquidity at Rs 422 billion exceeded the revised Credit Plan target by Rs 62 billion and was higher by Rs 64 billion than the corresponding period of last year.
The rise in money supply was mainly on account of private sector (up by Rs 390 billion or over 92 percent of total increase in money supply) followed by government sector and foreign sector which recorded increases of Rs 100 billion and Rs 42 billion respectively.
The rise in money supply would have been larger if Public Sector Enterprises (PSEs) and other items had not caused a contractionary impact during the year. Although monetary data for the whole year ie upto 30th June, 2005 would be available only after a few weeks, certain disturbing trends are quite obvious.
State Bank's Credit Plan projections have been exceeded by a wide margin despite its tightening of the monetary policy and its noble objective of keeping liquidity expansion much below the nominal growth of around 18 percent in GNP and GDP during 2004-05 to neutralise the monetary overhang of the last three years has not been achieved.
The issue is significant for a number of reasons. Excessive doses of liquidity were injected into the economy during FY02, FY03 and FY04 when monetary assets rose sharply by 15.4 percent, 18.0 percent and 19.6 percent respectively, but fortunately such an easy monetary stance was affordable, and even advocated in the name of recovery of the economy, due to a subdued inflation rate which remained below 5 percent during all these years.
The situation, however, changed drastically during 2004-05. The impact of excessive monetary expansion coupled with several other factors like hike in petroleum prices and occasional shortages of essential items began to be noticed in rising prices and the State Bank was forced to react aggressively, particularly in the last quarter of the outgoing year.
Whether the State Bank acted belatedly or less stringently is of course disputable, but its measures so far do not seem to have yielded the desired results in terms of exercising enough control on credit and monetary aggregates and taming inflation. Now the moot question is which way to proceed in the coming months.
Further tightening of monetary policy also has its pros and cons but the risk of mounting inflation is really frightening and needs to be countered without further delay.
However, the phenomenon is not that simple and several factors are usually at work at the same time. The State Bank's hesitation to act decisively could be seen in the latest auctions of T-bills auction when, contrary to the practice in the previous quarter, the rates on various tenures were kept, more or less, stable.
This conveyed the message to the market that the State Bank would like to wait and watch the latest inflationary trends, at least for the time being, before responding to the evolving situation. On the face of it, this appears to be a good strategy, but the overall situation has also to be seen from another angle. Government's appetite to absorb funds from the money market has a huge impact on the equilibrium interest rate and it becomes difficult for the State Bank to plan its strategy when signals from the government are not very clear.
The uncertainty is glaringly noticeable from the budget documents for the year 2005-06. The fiscal deficit for FY06 was set at Rs 285 billion, which was to be financed by:
(1) Rs 98 billion from the banking system;
(2) Rs 55 billion from non-bank sources;
(3) Rs 112 billion from external sources; and
(4) Rs 20 billion from privatisation proceeds.
One could only wonder how the budget makers could overlook the possibility of a much larger inflow of funds through privatisation proceeds and its impact on the fiscal and monetary scene, which is now a tangible fact. Perhaps the setback on KESC privatisation was the cause of this lapse.
The receipts of $2,598 million or Rs 156 billion from the sale proceeds of PTCL and the likelihood of the inflow of Rs 15 billion on account of National Refinery Limited would mean a considerable restructuring of the balance sheets of the banks with a probability of huge downward pressure on interest rates. The Privatisation Commission Ordinance, 2000 provides that the net privatisation proceeds received through the sale of enterprises owned by the Federal Government shall be transferred to the Federal Government which will be obliged to utilise 10 percent of these proceeds for poverty alleviation and the remaining 90 percent for retirement of the Federal Government debt.
The first-round impact of privatisation proceeds of the enterprises sold to foreign buyers like Etisalat, therefore, would be an increase in the "balances held outside Pakistan in approved foreign exchange" on the assets side and a corresponding increase in the rupee deposits of the Federal Government on the liabilities side in the balance sheet of the banking department of the State Bank.
Whereas the earmarking of funds for poverty alleviation would only call for better absorptive capacity and effective utilisation of funds, the mode of retirement of debt could be a difficult proposition. In case the government decides to retire foreign debt, deposits of Federal Government and approved foreign exchange with the State Bank will decline correspondingly, but it would not be easy to do.
Early retirement of debt has to be negotiated with foreign lenders which, given the present debt profile of the country, may involve very heavy penalties. On the other hand, if domestic debt has to be retired, its mode has also to be decided.
The government could buy back its securities from the State Bank or the scheduled banks or reduce its debt from non-bank sources by utilising its deposits with the State Bank. It could also try a combination of these approaches.
In any case, though the overall impact on balance sheets of banks may depend on the decision of the government, the market would remain flushed with liquidity and the State Bank would find it difficult to raise interest rates to contain inflation in this kind of environment.
Looking at the mounting criticism of the government's economic policy for its failure to provide relief to the common man, the government could also try the option of amending the Privatisation Commission Ordinance, 2000 in order to utilise the privatisation proceeds for budgetary purposes and at its own discretion.
Again, it would be very interesting to see whether the government would like to utilise these funds for long-term gains to the economy or only provide short-term relief to the people to please the galleries.
The need for domestic sources of financing would be effectively reduced to zero if the government sticks to the expenditures envisaged in the budget and the remaining gap could then be easily filled through the estimated external financing of Rs 112 billion.
In that case, the budget deficit would be substantially reduced and the government's funding position would become very strong with the result that there would be no need to borrow from any domestic source.
As the government would not pre-empt any liquidity from the market, the interest rates would tumble downwards, the government would not be keen to adjust NSS rates upward, the prices of real estate and in the equity market would continue to rise, demand for private sector credit including that for consumption purposes would remain strong and hoarders and speculators would again corner stocks to make undue profits.
Above all, it would be very difficult for the State Bank to follow a tight monetary policy and combat inflation unless and until it is prepared to issue its own paper to mop surplus liquidity from the market and forego profits transferable to the government.
However, the comfort from such a strategy would be that domestic debt would not increase during the course of the year which would be helpful in containing debt servicing burden of the country in future at a lower level.
Once the condition of debt retirement is relaxed, there would also be more popular and politically expedient options available to the government. Under the new scenario, the government could increase subsidies and other expenditures and at the same time maintain the level of fiscal deficit as stipulated in the budget.
For instance, the government would have the additional fiscal space to keep POL and utility prices stable by providing subsidies even if there is an abnormal increase in the international prices of oil. With the political sensitivity attached to essential food items, fiscal measures to provide such items at below market price may be undertaken.
Since the authorities would have ample reserves to finance the external gap, the urge to import various items would grow. Deposit mobilisation strategy of the banks may change due to the change in liquidity outlook. All of this may mean higher consumption levels in the economy and short-term relief to the people without corresponding increase in earnings and at the cost of frittering away family silver.
The desirability and sustainability of such a policy framework should be obvious to everybody.
It is clear from the above that fiscal policy and its outcome are bound to witness a sea change after a much larger inflow of privatisation proceeds than Rs 20 billion provided in the budget for 2005-06. It was rather unwise not to anticipate, even roughly, the full magnitude of these receipts at the time of formulation of the budget but the use of these proceeds now needs to be planned with utmost care and attention.
This is important because the difference in the way these proceeds are utilised could be very crucial for fiscal policy and economic fortunes of the country. The sale of national assets could only be justified if it is meant to reduce imbalances and vulnerability of the economy and enhance its efficiency and productivity in order to overcome the problems of poverty and unemployment.
The way privatisation proceeds are utilized would also have a crucial impact on the balance sheets of the banking system, interest rate structure, monetary policy of the State Bank and inflation rate in the country.
It would not be proper for us to pre-judge the matter and propose a certain policy option but monetary authorities of the country would have to be more vigilant, ready to reverse the trend of excessive liquidity expansion witnessed in the last four years even if it entails extraordinary techniques and expenditures, contain inflation to the target level of 8 percent and not allow the monetary policy to be hostage to fiscal developments.
In a country like Pakistan, nothing is more hurtful for the common people, especially the poor, than a consistent increase in prices. Hopefully, the Credit Plan and the Monetary Policy Statement (MPS) to be released by the State Bank shortly would take into account all these factors.