Taming inflation: pushing the boulder uphill

According to a recent survey, inflation and poverty are the biggest issues in Pakistan. No one could have any doubts about the findings. The question is: what are the drivers for this high inflation and how can they be tamed? Some argue that note printing (SBP injection of liquidity through open market operations –OMOs) is fueling the demand, connecting that to the falling foreign assets in the monetary composition.

Well, indeed squeezing foreign liquidity is putting pressure on the currency (and in turn inflation), and there are no doubts that growing OMOs constitute a big concern. However, these are perhaps effects, not the causes. It’s important to have a debate on causality. There are different factors and variables — both tangible and intangible — that are in play for rising inflation. It has many moving parts.

First, the money printing argument is somehow misplaced and being overemphasized. The broad money (M2) grew by 14 percent last year (FY23) while headline inflation was 29 percent and nominal GDP grew by 27 percent. This implies that the money supply growth is shrinking in real terms and so is the demand.

The money supply growth was higher than inflation in FY21 and FY22 and partially last year high inflation can be explained by the monetary overhang (as empirically monetary transmission takes 12-18 months in Pakistan), and late response by the SBP on monetary tightening.

However, money supply growth is lower than inflation since April 2022. Interestingly, it’s the same time when exceptional rise in OMO injection took place – it grew from Rs1.7 trillion in Dec 21 to Rs10 trillion in Aug 23. There are two takeaways – one that OMO injection is not fueling demand, and other that purely on demand factors, inflation should be significantly easing in the next 6-18 months.

Some may ask if the money supply is not growing why OMO is at a whopping Rs8 trillion (now) and why the government’s fiscal domestic financing touching Rs2.5 trillion in Jul-Sep quarter which is 2.8 times of the amount same period last year. There are reasons for these anomalies – such as retirement of foreign government debt (public and private), exceptional growth in currency in circulation (CIC) in FY23, and delay in staller SBP profits’ disbursement (as 40% of domestic debt is directly and indirectly (through OMOs) owned by the SBP).

General government external debt is down from $86.1 billion to $82.3 billion in FY23. This means (at an average PKR/USD of 248), Rs952 billion worth of foreign debt is being replaced by the domestic debt without any increase in the fiscal deficit. Then other sectors’ foreign debt is down too. Overall, Rs1.5 trillion worth of foreign debt is being replaced by the domestic, last year. Then CIC grew by Rs1.6 trillion in FY23 (2.4x the previous year). Then the private credit fell in FY23 by Rs1.7 trillion, as retirement is not replaced by new credit.

These three factors have substantially squeezed the domestic system liquidity, and SBP had to inject money (OMO) to fill in the gap. Thus, a significant part of obnoxious rise in OMOs is not a Viagra for the government, rather it is a compulsion due to system’s limitation in the absence of foreign liquidity, and growing informality in the domestic economy.

Nonetheless, the deteriorating NFA/NDA ratio is a big problem and is manifested by the currency devaluation. However, it should not be catastrophic. The ratio averaged at minus 3 percent in the last six years (FY18-23) versus 15 percent in the previous sixteen years (FY02-17). No doubt there is a steep and secular decline. However, the country has faced such times in its history – for example NFA/NDA ratio averaged at minus 2 percent from FY1975-2001 and ranged between 7 percent and minus 9 percent. The pattern of FY18-23 is like FY75-2001.

Thus, based on history, this should not result in hyperinflation and breaking down of the economic system. The question is then what are the other factors contributing to high inflation? It’s mainly the rise in commodity prices and massive currency devaluation. Then the delay in passing on rising commodity prices (in 1HCY22) has a direct (sudden jump in prices) and indirect impact (growing fiscal deficit) on the inflation.

However, that year is behind us. Now the second round of inflation is in play, as wages are being passed on (this is suggested by pick up in core inflation). The good news is that in the last quarter (Jul-Sep 23), fiscal behavior is much better. Petroleum and electricity prices have timely increased to ensure (almost) full taxation and to plug in the flow of circular debt. FBR tax collection has surpassed the target. SBP’s NDA target has been met. Reserve money (M0) growth is in check as CIC is falling and SBP ‘s NFA is growing. This implies that IMF’s NIR (net international reserves), foreign currency swaps/forward and primary fiscal deficits targets are likely to be met as well. And the domestic liquidity may improve in the second quarter, as SBP profits for FY23 to be transferred to the government (expected inflow of Rs1.2 trillion).

This shows that there are some marginal improvements lately on tangible factors to tame inflation. However, the core issue is the fiscal deficit. That must be cut significantly. The government should slash development spending to almost zero, and work on reducing the size of the government and its institutions – not an easy job, especially in a fluid political and economic situation. And these steps would compromise growth for the next few years.

The government should expand the tax base. Everyone talks about real estate, retail, and wholesale. But no one talks about taxing the hefty capital gains commodity dealers (in sugar, urea, and other commodities) and currency traders made in the last year. The government should tax them and continue this crackdown on smugglers and hoarders.

These may help in reviving some confidence and taming the un-anchoring inflation to an extent. However, the currency cannot be controlled, and the inflation expectations cannot be anchored without restoring confidence, which is eroded due to the intangible factors, as there are no macro indicators that can explain moving the PKR/USD from 180 to 300 in 1.5 years. At the end it’s a crisis of confidence that is causing unprecedented inflation. That cannot be restored without bringing political stability and gaining confidence of domestic businesses.

Copyright Business Recorder, 2023