On balance, the State Bank's decision on 29th January, 2011 to keep the policy rate unchanged at 14 percent may not be very unjustified, but some of the reasons given for this decision are based on hopes that are not likely to materialise. Analysing the overall economic situation in the monetary policy statement (MPS), the central bank, as in the past, is quite certain that "fiscal deficit and borrowings from the banking system is continuing to stoke inflationary pressures."
Inflation that was already high in the beginning of the fiscal year has remained at elevated levels, with the year-on-year CPI increase at 15.5 percent in December, 2010. Acute energy shortages were contributing to the underutilisation of existing productive capacity and discouraging new investment, with the result that the aggregate demand and supply gap was still large enough to push inflation further. Surging international food and commodity prices were also playing a role in intensifying expectation of rising domestic inflation.
The revised projection for CPI inflation during FY11 is in the range of 15 to 16 percent, with a high probability of double digit inflation in FY12. "To bring inflation under better control, the critical measures would be fiscal consolidation and reduction in fiscal deficit and government borrowings from the SBP." However, due to a shortfall in revenues, and rise in expenditures, especially in the aftermath of the floods, it would be a severe challenge to even meet the revised fiscal deficit target in the absence of critical reforms.
It was very important now for the government to spell out a clear and coherent strategy to limit fiscal slippages, when proposed reforms in the GST, along with other tax measures have been postponed and the decision of increasing the retail prices of petroleum products w.e.f. January 1, 2011 has been reversed. While welcoming a nominal surplus in the current account of the country, the State Bank has also noted that "given a decline in financial inflows, the financing of even a smaller current account deficit for FY11 (projected at 1.5 percent of the GDP) could pose challenges for an adequate build-up of foreign exchange reserves."
While marshalling most of the arguments for tightening the monetary stance still further, the State Bank deemed it fit not to change gears in the hope of certain positive developments that provide "sources of comfort." Firstly, the SBP anticipates that since an understanding has been reached with the government that it will restrict its borrowings from the central bank to below the end-September, 2010 stock of Rs 1,290 billion, the current shift from SBP financing will be consolidated.
Secondly, the risk of fiscal problems have not so far slipped into the external account, thereby providing still an opportunity to address the persistent fiscal issues. And thirdly, the SBP was optimistic that the "recent multi-partisan efforts would improve fiscal revenues and curb current spending (one-off and continuous)."
In order to further strengthen its case for keeping the policy rate unchanged, the State Bank, as usual, also referred to "the delicate balance that needs to be struck between risks to inflation and economic growth," with the customary explanation that "the future course of action would be contingent upon the expected progress of key areas of concern to the SBP."
We feel that the case for continuing with the existing monetary policy stance or tightening it further (the market was expecting an increase of about 0.5 percentage points in the policy rate) was almost equally balanced. While the latest fiscal and inflation indicators called for a more stringent monetary policy, the outcome in the current account balance during July-December, 2010 definitely provided a zone of comfort for a pause.
Also, the State Bank may well argue that, after three consecutive increases in the policy rate in the last eight months, it would like to analyse the full impact of these increases before hiking the rate further. The arguments for supply side bottlenecks and stagnating growth for fuelling inflationary pressures in the economy do have some merit.
These, in our view, were good enough reasons for the State Bank to stay put for the time being, wait for more relevant data to unfold and decide for the next move after two months. After all, its judgement counts more than everything else and it has the sole prerogative to formulate the monetary policy of the country. By falling into the trap of zones of comfort for keeping its stance unchanged, the State Bank seems to have demonstrated that it was relying more on promises which are likely to prove illusory, rather than its experience of the past or facts on the ground.
As to why optimism of the State Bank seems to be misplaced is not hard to visualise. The basic source of comfort for the SBP is the recent multi-partisan efforts that, in its opinion, are likely to improve fiscal revenues and curb spending and its understanding with the government to restrict borrowings from the State Bank to below the end-September stock of nearly Rs 1,300 billion. On the face of it, the achievements expected by the SBP would be stupendous, to say the least, and should generate a lot of optimism but such a miracle is not likely to happen.
The fact of the matter is that public finances of the country are in extremely poor shape, getting worse by the day and multi-partisan efforts may fail to yield the desired results. The central bank must be aware that the revised deficit target of 4.7 percent, as mentioned in the MPS, is highly underestimated and the government is already talking about a budget deficit of more than 8 percent of the GDP due to massive resistance against implementing the fiscal reforms.
One cannot expect the parliamentary representatives to easily join the efforts to impose the RGST or pass on the rise in the international prices of oil to the domestic market when they themselves had opposed these measures and forced the government to submit to their demands. It needs to be recognised that in a democratic set-up, political posturing in order to please the gallery often takes precedence over economic imperatives. As far as its' understanding with the government not to exceed the end-September, 2010 borrowing limit is concerned, the less said, the better.
In a country where the FRDL Act, 2005, duly passed by the parliament and the SBP Act, giving autonomy to the State Bank to determine the limits of government borrowings, have not been able to force the fiscal authorities to adhere to proper financial discipline, it would be naïve to expect the government to honour a mere understanding with the central bank.
Experience suggests that it is impossible to stop the government from violating such assurances when the chips are down. It would also not be very prudent to attach high hopes to the recent improvement in the current account of the country which is primarily based on transitory factors. This is not to say that the State Bank has erred by keeping the monetary stance unchanged, but only to emphasise the point that its policy formulation should be guided essentially by the relevant available data and not by conjectures or high hopes.
For the conduct of a proper monetary policy, it is of course indispensable to bring some sanity to the fiscal management of the country without further loss of time. While the issue of the RGST, and other revenue mobilising measures or multi-partisan efforts can be considered in a broader context, it is imperative to contain government debt within the limits stipulated under the FRDL Act, 2005 at the earliest and take the necessary steps to bring the matter before parliament if its constitutional provisions have already been violated.
Also, the government and opposition parties need to cooperate and act immediately to pass on the rise in the international prices of oil failing which, the problem of circular debt and budget deficit would worsen further, leading to highly undesirable consequences. Independent nations cannot afford to indulge in irresponsible fiscal behaviour for an extended period.
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