Fighting inflation

These are difficult times for central banks of oil importing countries. Faced with the unusual phenomenon of skyrocketing oil and food prices impacting adversely their economies in a number of ways, they are forced to adopt highly restrictive measures to perform their primary function of ensuring price stability.
The State Bank of Pakistan (SBP) on 22nd May, 2008, responded to the deteriorating situation by announcing a series of monetary tightening measures and explaining their rationale and background in order to pre-empt unnecessary criticism on its move. The policy measures announced by the SBP were wide-ranging and encompassed almost all areas and instruments of credit and monetary control at its disposal.
The policy discount rate was increased by 150 basis points to 12 percent, Statutory Liquidity Ratio (SLR) and Cash Reserve Requirement (CRR) for deposits up to one year maturity were hiked by 100 basis points to 19 and nine percent respectively, and all banks were required to pay a minimum profit rate of five percent on saving/PLS products. The L/C margin of 35 percent was imposed on all imports except for oil and selective food items. These strong measures were meant to tame inflationary pressures in the economy by increasing the cost of credit, encouraging savings and draining off excess liquidity from the system as well as reducing import demand with a view to improving the balance of payments of the country and countering the weakening of the Pak Rupee.
The State Bank this time has not stopped at prescribing these stringent measures but has also advised the government to sterilise the expected foreign inflows by using them to settle its obligations to SBP, retire its MRTBs to help reduce the reserve money growth, and amend the Fiscal Responsibility Debt Limitation (FRDL) Act of 2005 for incorporating appropriate provisions to restrict debt magnetisation.
The reasons given by the SBP for adopting this highly restrictive approach are quite convincing. A considerable deviation of Pakistan's macro-economic outcome for FY08 from the original projections, according to the State Bank, has necessitated re-examination of the monetary policy framework that was based on different assumptions related to fiscal and external account deficits as well as output growth and inflation. "The slippages in the twin deficits and borrowings of the government from the SBP have grown persistently every month. Equally concerning is steady rise, but now a sharp spike in year-on-year indicator of food inflation.
These trends have reached a proportion that are now unsustainable and without corrective actions carry risk of creating more macro-economic complications". The immediate monetary policy tightening was necessitated by some unprecedented pressures on the economy.
External current account deficit has increased at a pace that is difficult to sustain given the slowdown in financial inflows, complications in financing of external current account deficit coupled with speculative positions in the domestic foreign exchange market, which have put enormous pressure on the exchange rate; budget deficit is projected to be significantly higher relative to the original budgetary estimates for FY08, private sector credit has grown consistently and has outpaced last year's growth despite monetary tightening in January and the combination of these developments has raised the headline inflation to an alarming level, doubling in just four months from December, 2007 to April, 2008.
More disturbing was the trend of food inflation, which has also doubled, spiking to 25.5 percent from 12.2 percent during the same period. There is absolutely no doubt that, like most other central banks, this is testing time for the State Bank and it has to take unusually tough decisions to counter high inflationary pressures in the economy and protect the solvency of the country.
Most of the oil importing countries are now registering a slowdown in their economic growth and witnessing exceptional rise in inflation which is emerging as the biggest challenge and Pakistan is no exception to these developments. In fact, while record oil and food prices in the international market are a source of great stress for almost all the countries, Pakistan's problems have been exacerbated by political uncertainty, lower foreign investment, and the unwillingness of the government to adapt its fiscal strategy to the unfolding events.
Based on current trends, the average headline inflation for the entire FY08 is forecast to be over 11 percent - almost double the target of 6.5 percent - and the situation has the potential to explode in hyper inflation if the State Bank does not watch the situation carefully and take highly pro-active measures to manage domestic demand pressures to avoid further and steeper rise in inflation.
In our view, the measures announced by the State Bank including increase in the discount rate, SLR and CRR would raise the cost of credit, reduce the credit creating capacity of the banks and be very helpful in containing the growth of liquidity in the economy. The rise in deposit rates almost across the board would encourage saving habit and shift a part of currency holding by the public to their deposit accounts.
All of this will reduce demand pressures in the economy and tame the emerging inflationary pressures; though in a volatile and uncertain situation the country is facing at present, it is difficult to quantify the net positive impact of the measures announced by the SBP. The reduced import demand coupled with higher L/C margins and relatively better return on rupee deposit accounts will also be helpful in improving the current account of the country.
However, government and businessmen are expected to be critical of the State Bank's measures for obvious reasons. We feel that the State Bank has done well to point out openly the inevitability of the measures in the current economic situation and by reminding that the real lending rates in Pakistan would still be one of the lowest in the world.
It needs to be highlighted, however, that the success of monetary tightening measures would depend critically on the fiscal strategy of the government. In its statements and documents, the State Bank has all along been urging upon the government to reduce the budget deficit to sustainable levels and finance it from sources other than the State Bank in order to soften its inflationary impact.
Upward revision in NSF rates, enhancing the attractiveness of prize bonds scheme and holding a series of PIB auctions to tap corporate savings need to be focused on to retire the T-bills holding of SBP. So far, the government has not listened to State Bank's advice and complemented its tight policy by adopting the necessary contractionary measures with the result that monetary policy is becoming increasingly hostage to the expansionary fiscal strategy of the government.
It is apparent that the government has to seek a waiver from the parliament for missing the fiscal conditionalities under FRDL Act, 2005 during 2007-08 because of much higher level of fiscal deficit than the prescribed target. While the need for fiscal prudence and a close coordination between monetary and fiscal policies to achieve the desired results is obvious, it is not clear why the State Bank has advised the government to amend the FRDL Act.
If excessive borrowings from the SBP are to be discouraged, the purpose could be served by invoking Article 9A of the State Bank Act which states that its Central Board could "determine and enforce, in addition to the overall expansion of liquidity, the limit of credit to be extended by the Bank to the Federal Government, Provincial Governments and other agencies of the Federal and Provincial Government for all purposes..." Even otherwise, we would advise the State Bank to be a little cautious in its approach and remember that its hard-won autonomy could be rolled back through a revision in its Act by a Parliament that does not like its posture and is wary of its interference in managing government accounts.