Will a raise in State Bank of Pakistan (SBP) policy rate be beneficial or harmful for economic growth? Its answer lies in our profound fiscal woes because monetary policy has consistently been held hostage by fiscal breaches and as a result, the effectiveness of monetary policy transmission has always been weak.
In other words, fiscal policy has not been accommodative to monetary tightening. These key policies - fiscal and monetary - are, unfortunately, not working in tandem. It is now increasingly feared that the fiscal deficit may be six percent plus against government's aim to restrict it to 5.1 percent of GDP - which clearly needs to be brought down - despite M2 growth of 12.46 percent being much lower than a nominal growth of about 16 percent (GDP + inflation). The composition of monetary expansion is also not in accordance with the needs of the economy. The rise in forex reserves to cover a larger portion of imports was diluted by a faster than projected increase in government borrowing from the central bank.
The only silver lining is the improvement in the current account deficit - down to two percent of GDP. The dip in imports on a larger base was more instrumental in improvement of trade deficit and overall balance of payment than the rise in country's $19.38 billion exports that surpassed the set target of $18.7 billion for FY2009-10. The challenge is to sustain the current account deficit within this range over short/medium term through increase in export of goods and services, including home remittances and through foreign direct investment and not merely through grants, loans and aids.
Easing of commodity prices and appreciable slowdown in import demand is clearly visible in the improvement in the current account deficit. With economic slowdown becoming more pronounced, our economic managers are struggling to live from quarter to quarter to meet the floor on forex holding and the ceiling on expenditure targets, agreed with the International Monetary Fund. Unfortunately, however, a strong political will to undertake necessary stabilisation measures whose underlying objective is to keep the twin deficits - current account and fiscal - within tolerable range on a sustainable basis to achieve macroeconomic stability is not there.
We are afraid further tightening of monetary policy through an increase in the SBP policy rate at this stage will not result in either forcing the government to reduce its bank borrowing (both from SBP and commercial banks) or help in overcoming supply side induced price hikes. Mismanagement in timely imports of sugar is a prime example. A rate hike, however, would send a strong signal to the private sector to hold back on investment. It will compromise even our moderate growth target of 4 percent for FY11.
Moreover, it could result in increasing the size of non-performing loans in the banking sector as the floating rate (Kibor) will go up, increasing the possibility of borrowers defaulting on timely servicing of loans at such high rates. Even the government, which is groaning under heavy borrowing, would come under some added fiscal pressure.
It can safely be argued that under present circumstances, monetary policy has lost its effectiveness. Despite a slowdown in M2 growth, the reserve money rise is in double digits (10.2%) as government has been borrowing with abandon throughout every quarter. It has struggled to reduce its fiscal deficit at the end of every quarter to achieve performance criteria target of the Fund with receipt of dividends from the central bank (Rs 100 billion) and a reduction in net foreign assets holding of SBP to contain the net domestic assets of SBP. This surely does not help in reducing inflationary pressure because increased government borrowing from the central bank increases money supply, which in turn can fuel inflation.
Economists regard supply side shortages as a temporary phenomenon. In our case, however, it is not. We continue to suffer with an inefficient supply side structure. Maintaining the policy rate at current level implies keeping the base of credit unchanged for both the private sector and the government. Raising the rate to reduce demand and curb inflationary pressures would result in reduction in credit space for private sector without forcing the government to borrow less. Let us face facts. SBP is legally empowered not to lend to the government. But the reality is altogether different. The present incumbent has an "acting" charge. The political leadership at the helm would like the SBP to be an adjunct department of the Ministry of Finance.
Theoretically, raising the rate to bring inflation rate down would make a greater economic sense. The easy option is to maintain the policy rate at current level. Reducing the rate requires some deep insights into the consequences of such a bold decision as tackling the mess through growth will be challenging but is doable. Meanwhile, the economy will continue to muddle along at a slow pace unless there is major breakthrough in appreciable enhancement of revenue coupled with a substantial reduction in subsidy from the federal budget on account of losses of public sector enterprises. With federal and provincial governments at loggerheads on VAT collection and playing a ping-pong game on who would complete the much needed development projects - the current economic scenario looks rather bleak - as we seem to be drifting away from the objective of macroeconomic stability. The present economic situation was expected, it is disappointing nevertheless.
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