Turning the screws

The Monetary Policy Statement (MPS) for July-December, 2006, issued by the State Bank of Pakistan (SBP) on 29th July 2006, says in no uncertain terms that the objective of monetary policy during FY07 would be price stability and growth, "though the current balance of risk requires greater focus on containing inflation".
As such, the SBP would maintain its tight monetary stance during July-September, 2006. However, it will continue to monitor the risks to the economy and would be prepared to modify its policies appropriately in order to protect the long-term growth prospects of the economy.
As for the historical perspective, with inflation at very low levels since FY01, monetary policy had greater bias towards supporting growth. "With the inflationary pressures building up, from early FY05 monetary policy stance has squarely tilted towards inflation containment". The firm steps taken to tighten monetary policy together with the government's administrative measures have helped scale down the inflation rate to the targeted level during 2005-06.
The State Bank also seems to be fully aware of the policy challenges to be confronted in the coming period. Despite monetary tightening, money supply (M2) during 2005-06 grew by 15.0 percent, which was higher than the target, leading to a robust growth in aggregate demand.
The demand pressures will be further boosted in the current year by the fiscal stimulus provided by the government "to accelerate the much warranted social and infrastructure spending". It means "the burden of containing aggregate demand, in order to keep inflation in check, must then necessarily fall on monetary policy".
The challenges for the monetary policy would be further compounded by a rise in external pressures as the current account deficit during the current year is expected to widen beyond the FY06 level. The options to deal with the rising current account deficit range from drawdown in reserves or increased reliance on external borrowings, but obviously these are undesirable options due to their negative impact on the long-term economic growth. The State Bank would surely prefer moderation in the aggregate demand through the continuation of a tight monetary policy.
At a time when the incipient inflationary pressures are high, the meeting of inflation target of 6.5 percent for FY07 poses a huge challenge to the State Bank.
The recent policy moves of the State Bank are geared towards achieving the desired objective of containing aggregate demand in the economy. It has enhanced frequency and intensity of open market operations to manage the banking system liquidity and increased the reserve ratios in July 2006.
At the same time, the MPS has clearly called upon the government to reflect on its domestic borrowing strategy to ensure "that budget recourse to central bank is curtailed by enhancing reliance on non-bank financing options. Besides helping to mitigate inflationary consequences, this borrowing strategy would help stretch the maturity of domestic borrowings, while ensuring offering market a benchmark to issue long-term papers".
We feel that most of the observations in the MPS are appropriate to the situation.
The fact that these were also contained in the third quarterly report issued by the State Bank only a fortnight ago does not mean that they have lost their relevance or importance. Obviously, the central bank appears to be greatly concerned about the risks associated with the increase in inflationary pressures, the emerging weakness in fiscal indicators and the widening of current account deficit.
In the last one-year or so, it has indicated the need of taking corrective policy measures on various occasions to protect long-term growth prospects of the economy. On its part, it took the initiative to increase the CRR and SLR substantially on 18th July 2006 so that the credit creating capacity of the banks may be reduced considerably and the growth in domestic assets and liquidity contained within reasonable limits.
We believe that this measure would help reduce demand pressures in the economy and soften inflationary pressures with the passage of time, though it is too early to say whether the inflationary target of 6.5 percent will be achieved or not during 2006-07.
We would urge the government to do its part as well so that the job of the State Bank to contain inflation at the targeted level becomes easy and further harsh monetary measures can be avoided. In particular, the government needs to curtail the budget deficit to around three percent of GDP and finance it through domestic non-bank borrowings as suggested by the SBP in its MPS.
Issuance of long-term paper, ie, PIBs, in greater amounts and more frequently would not only serve this purpose but also set a benchmark for interest rate structure in the economy.
As indicated by the State Bank in the MPS, it has already started the process of turning the screws so far as monetary management is concerned. Reserve ratios were enhanced considerably in the third week of July 2006 and the discount rate was raised by 50 basis points to 9.5 percent on the very day the MPS was announced.
These three major initiatives in a single month would drain out a substantial amount of liquidity from the market, make money more expensive and help curb inflationary tendencies in the economy. A reasonable rate of inflation (lower than the threshold level of 5-9 percent has been suggested in the MPS) would not only help sustain long-term growth but also improve the external sector situation of the country.
Hopefully, the State Bank, from now onwards, would keep a very close watch on the monetary aggregates to judge the effectiveness of its recent initiatives. As is evident, the average money supply growth of 18 percent during the last four years was on a very high side and needs to be brought down considerably to achieve the desired objectives. If that does not happen, the screws may have to be tightened further by the State Bank.