Monetary policy and SBP

Monetary policy is an important component of a macroeconomic policy framework in any country. Similarly, central banks, whatever their level of statutory autonomy, play a key role in the formulation of a macroeconomic framework, particularly monetary policy. In the United States and Germany, the central banks are so autonomous in the formulation and implementation of their monetary policies that neither the chief executive of the country nor legislature can directly or indirectly interfere in their work.
Even in the UK and New Zealand, where the central banks did not have much of autonomy, the conduct of monetary policy is the responsibility of their central banks.
In the case of Pakistan, the history of monetary policy is much checkered, and even confusing, particularly to those who may not have had long association with the State Bank of Pakistan (SBP) or real understanding of the legislative history of revisions in the SBP Act.
The original SBP Act of 1956 had provisions in it that allowed the federal government to administratively control the functioning of the SBP and most of the decisions of its management and board were subject to approval by the federal government. In particular, the SBP could not use any of the traditional instruments of monetary policy available to central banks without prior clearance of the federal government. With its nationalisation and that of commercial banks in early 1970s,the supervision of the banking system was also effectively taken over by the Pakistan Banking Council (PBC) that worked under direct administrative control of the ministry of finance.
Even with these legal limitations, the SBP played a useful role in economic management of the country, and remained active in the conduct of monetary policy and regulation of the banking system. The solid team of professional central bankers and economists that it was able to gather, made it sure to lend technical and moral support to even those governors who seemed to be relatively unpreparedto be assertive in presenting the SBP viewpoint to the government or undertaking SBP central banking functions.
However, with rapid deterioration of the public finances of the government from the 1980s, its excessive use of money creation as a source of expenditure financing, introduction of specialised credit schemes and interest rate distortions by, or under the directions of, the government, it was increasingly felt that the SBP needed to be given administrative autonomy and independence in the formulation and conduct of a market-based monetary policy and regulation of banks in order to ensure monetary and price stability and contribute to fuller utilisation of the country's productive resources.
Beginning with the interim government of Moeen Qureshi in 1993, it took four years and a great deal of struggle to get legislation passed by the then two interim and two regular governments to give the SBP autonomy, particularly in the matter of monetary policy. At the same time, the SBP developed analytical and institutional capacity, and reached an understanding with the ministry of finance, for the conduct of monetary policy under the new legal framework. For the first time in its history, the SBP was able to formulate monetary policy independently for the FY 1997-98.
It was based on the following arrangement that was defined in the new section 9 B of the SBP Act and agreed with the ministry of finance:
* Much before the budget time, the Monetary and Fiscal Policies Co-ordination Board (MFPCB), set up under the new section 9 B of the SBP Act, convened and agreed on the growth, price and balance of payments targets
* The SBP used its macroeconomic framework and reserve money management programme to determine the level of government borrowing from the SBP that was consistent with the targets of growth, prices and balance of payments. After its approval by the board of directors, scope of government borrowing for the next year was conveyed to the ministry of finance which inter alia prepared its budget based on SBP input on bank financing of the budget.
* Based on the monetary policy approved by the board of directors, the SBP began to implement it using the monetary tools that by then were legally put at the exclusive disposal of the SBP;
* The quarterly mandatory meetings of the MFPCB were regularly held to review and co-ordinate fiscal, monetary, exchange rate and foreign trade policies.
The above arrangement was abandoned after the change of government in late 1999, and gradually the ministry of finance began to assert itself again in the matters of monetary policy. As the country was in a Stand-by Arrangement with the IMF during larger part of the first decade of 2000, the abandonment of the above arrangement in the formulation and implementation of monetary policy did not make much of a practical difference because the government had to agree on monetary programme and ceilings on government bank borrowing that were consistent with the targets of growth, inflation and balance of payments under the IMF Stand-by Arrangement.
However, what was done in the process was to push aside both the new legal framework and analytical and institutional arrangement worked out by the SBP for the implementation of monetary policy under the amended SBP Act. With the passage of time, and abandonment of the IMF programme, the de facto situation got entrenched even in the presence of contrary de jure provisions/arrangements that by then stood shelved and forgotten.
The recent monetary developments and monetary policy statements as well as SBP annual and quarterly reports make it very clear that government borrowing from the SBP and commercial banks are exclusively decided on fiscal policy considerations by the ministry of finance in violation of section 9 of the SBP Act, and regardless of their implications for the monetary policy and the monetary outcome. As a result, the reserve money and the net domestic assets of the banking system are in practice predominantly determined by government fiscal decisions. The SBP does not have an exclusive control on its own balance sheet and without it the SBP cannot have autonomy in the conduct of monetary policy.
The SBP itself has by now accepted a limited role of announcing "the policy rate" at which commercial banks can borrow from the SBP. But the SBP, as a central bank, should know better that the policy rate is an instrument of monetary policy and not monetary policy in itself. Monetary Policy has many tools with which to regulate money supply, including the policy rate, to control inflation.
At present, 80-90 percent of the reserve money and the net domestic assets of the banking system are created by fiscal decisions-making it impossible for the SBP to have control on monetary aggregates. In the last four years, the money supply (M2) increased at an annual average rate of 15 percent while the economy grew by only 3.4 percent leaving a wide "inflationary gap" that contributed to a high rate of inflation.
Obviously, laws are as good as their implementation and without de facto use of its legally sanctioned independence, the SBP cannot play its rightful role in the conduct of monetary policy. Any further change in law cannot ensure operational SBP autonomy but willingness and ability of the governor and the board to adhere to enforce existing provisions of section 9A and 9B of the SBP act will make it so.
(The writer is a former governor of State Bank of Pakistan)