The major problems, the economy of Pakistan is facing in recent years, are the macroeconomic imbalances and sluggishness of the economy. On the one hand, the whole burden lies on the shoulders of vulnerable class in the form of high food and non-food prices and low level of income. On the other hand, the macroeconomic policies of the government badly ruin the lower class of the society.
Presently, the economy of Pakistan is facing some serious threats in the form of high fiscal deficit, current account deficit, war on terror and food shortage etc. The devastation caused by floods has been unprecedented. It engulfed the whole nation and created a humanitarian catastrophe in the country.
It has badly affected the agriculture sector as standing crops on million of acres were washed away by flash floods, thousands of hectors of arable land were destroyed and millions of houses were washed away by the floods. In this situation proper formulation and implementation of economic policies can help cure these economic ailments. Monetary policy, in this regard, plays a pivotal role in promoting economic growth and price stability.
Keeping in view the heighten prices in the country, on 25th of March, the State Bank of Pakistan announced a monetary policy by keeping constant its benchmark interest rate at 14 percent with the aim of curbing high inflation prevailing in the economy. Since 2005, SBP has used interest rate as a main weapon in formulation of monetary policy.
The announcement of such a strict policy may lead to serious economic condition and may have some serious macroeconomic implication for the economy of Pakistan that has very low growth potential. The growth momentum of economy is also very sluggish. The policy makers should accept one thing that the sources of inflation in Pakistan are non monetary rather than monetary. Inflation in Pakistan is largely affected by the expectations and supply side factors.
High fiscal deficit and rise in non-performing loans (NPLs) are the important sources of inflation in recent years. The catastrophic floods have further heightened inflationary pressure in the country. Furthermore, the reformed GST would play a critical role in heighten prices in the country.
The problem of unemployment situation is worsened. Damocles' sword of hunger, starvation and deprivation is hanging over the head of masses while millions of people are homeless, jobless and even deprived of basic necessities of life, aggregate demand and output growths are very sluggish. The economy is in dire need of a big push in the form of high investment.
However, the increase in interest rate by the policy makers will lead to crowding out of private investment. Moreover, high interest rate will further worsen the situation of fiscal deficit because of high interest payment by the government in the wake of high borrowing from the private sector. On the one side, the SBP is trying to aggravate the liquidity crunch in order to stabilise the prices; on the other side, the circulation of money is expected to increase because of increase borrowing by the government to finance its high expenditures.
The very next problem the country will face after the announcement of monetary policy is the unattended inflation in the wake of high external loans and the surge in international oil prices after the conflict in Libya and other central Asia countries.
The data and empirical studies regarding the interest rate, output growth, fiscal deficit and inflation show that policy rate has a very low contact with inflation in Pakistan. Since 2005 and onward, there seems a positive correlation between policy rate and general price level. Moreover, there is also a positive relationship between interest rate and fiscal deficit.
It is due to the fact that high interest rate increases interest payment on government debt that leads to even higher budget deficit. Further, an increase in government spending that result from higher interest rate creates a competition for loans between public and private sectors that in turn crowds out private sector investment and consumption.
Debt overhanging is one of the most critical problems faced by Pakistan that is primarily due to higher budget deficits. The recent monetary policies would further worsen the situation. Unless fiscal deficits are controlled, it would result in mounting government debt. The empirical studies show a negative relationship between high interest rate and real GDP growth rate. Further, high fiscal deficit negatively affect economic growth.
Figure 1: Interest rate and Inflation
Source: State Bank of Pakistan
In such a state of affairs, when the growth process of the economy is inundated, the burden lies on the shoulders of government to keep its budget deficit under control. Otherwise, the country may bear the cost of high inflation and low output growth. However, the cutback in fiscal deficit must be due to reduction in the policy rate by the SBP that in turn would lessen the interest payment of the government and hence, private investment and GDP growth rate will increase.
(The writers are respectively Lecturer in Economics at University of Swat, Assistant Professor at University of Swat and Student of MSc Economics at GPG Jahanzeb College Saidu Sharif Swat). ([email protected], [email protected])
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