Increase in discount rate

The State Bank of Pakistan (SBP), it seems, has to play second fiddle during the period of the macroeconomic stabilisation programme likely to be concluded with the IMF in the next few days. At a time when it was busy injecting high doses of liquidity through successive reductions in cash reserve requirement (CRR), lowering of SLR and liberalising the export finance scheme to avert recessionary tendencies in the economy, the IMF, by all indications, put its foot down to effect a change in the course of monetary policy.
As some reports suggest, the government of Pakistan has agreed in principle with the Fund to raise the discount rate by 350 basis points in two phases. An increase of 200 basis points was mandated to be made effective before the programme was approved by the Board of the IMF, while the rise of another 150 basis points would be dependent on the behaviour of relevant indicators in the coming weeks.
The holding of an emergency Board meeting and announcement of a two percentage point increase in the bank rate on 12th November, 2008 by the State Bank, therefore, was a mere formality to regularise a precondition to enter the Fund programme.
To be fair to the government, it had no alternative but to yield to the IMF conditions to get its assistance due to the rapidly dwindling foreign exchange reserves and the fear of default on foreign payment obligations after a few weeks. The inability or the indifference of the friendly countries and other IFIs to extend financial support at this critical juncture without a positive nod from the Fund had literally left the country with no other option.
In fact, the action of the State Bank was clearly anticipated after negotiations with the IMF in Dubai, that the money market had already adjusted itself to the new situation and the exact increase in discount rate was widely reported by the media before it was actually announced.
Although IMF pressure appears to be the immediate reason for the hike in discount rate, the tightening of monetary policy is justified on some solid grounds. Defending the State Bank's action at a press conference, the Governor asserted that the decision was motivated by a number of factors. Despite several restrictive measures taken during 2008, including the hike in discount rate to 13 percent, inflationary pressures in the economy had not abated so far.
Inflation, as measured by the CPI, had gone up by 25 percent and core inflation by about 22 percent during July-October 2008 as compared to the corresponding period last year. Food inflation was even higher at 34 percent, pushing a lot of people below the poverty line and making their lives more miserable.
Inflationary expectations have strengthened due to pass through of international oil prices in the domestic market, increases in the electricity tariff and general sales tax, and the rising exchange rate depreciation. If the present trends continue, inflation during 2008-09 could reach as high as 21 percent as against the target of 11 percent set for the fiscal year.
The outcome in the external sector has been equally bad. Despite a reasonable increase in exports and workers' remittances, the growth of import bill by 35.2 percent has raised current account deficit to $5.9 billion during July-October 2008. With financial flows slowing down to $1.1 billion, this deficit had to be financed by a depletion of foreign exchange reserves amounting to $5.0 billion since the beginning of the fiscal year until 10th November 2008.
Total foreign exchange reserves are now equivalent to finance only nine weeks of country's imports. Although the recent decline in international oil and other commodity prices bodes well for the external sector, a sustained reduction in import demand remains critical to avoid further loss in reserves.
As per SBP estimates, current account deficit during this fiscal year was projected to be between 6.2 and 6.8 percent of GDP while the financing gap was expected to be around $4.5 billion. This is simply unsustainable. According to a paper on "Interim Monetary Policy Measures" circulated during the press conference, the raising of policy rate from 13 percent to 15 percent will not only help in aligning aggregate demand with supply, but will also provide room to accommodate government's financing requirements from the commercial banks.
Besides, the measure will calm the sentiment in the foreign exchange market and stem the second round impact of high inflation from spreading further. However, it was emphasised that appropriate monetary policy stance was only one ingredient of the macroeconomic stabilisation programme and its effectiveness would depend on proper co-ordination with fiscal and external sector policies.
Responding to the expected criticism on tightening of monetary policy when most of the other countries were doing quite the opposite, the Governor argued that diagnostics of economic situation in Pakistan were different from global and regional developments and, therefore, policy responses have to be different.
While a number of advanced countries were facing severe liquidity crisis, which transformed into solvency crisis, the macroeconomic fundamentals of these countries, to start with, were in order. In Pakistan, on the other hand, there were no insolvency problems but fiscal and external account deficits had reached unsustainable levels and the inflation rate was alarming.
Thus the State Bank had to launch sharper monetary tightening to tame the demand pressures and restore macroeconomic stability. However, in order to accommodate exceptional liquidity requirements of the banking system, the State Bank had provided a liquidity comfort of Rs 319.5 billion by lowering the reserve ratios and liberalising the export finance scheme under various heads.
Incidentally, the panel of economists led by Hafiz Pasha and constituted by the Government to devise a home grown economic stabilisation plan had also recommended enhancement in the SBP discount rate by two percentage points in one go which exhibits a convergence of views between independent economists, the IMF and now the State Bank about the conduct of monetary policy in the given circumstances.
However, while justifying the increase in discount rate by two percentage points to 15 percent, we should not forget the cost to be borne by the country in terms of reduced economic activity, lower growth and rise in unemployment and poverty levels. The likely reduction in budget deficit will magnify these costs.
But these costs are necessary to restore macroeconomic stability, ensure solvency of the country and keep the IMF on board. Some analysts are of the view that since the previous tightening of monetary policy had yet to show its full effect and the global commodity price trends were now favourable, it would have been better to watch the situation in the next few months and then devise the appropriate policy responses, including the monetary stance.
In that case, the stabilisation or recovery process could have been U-shaped rather than V-shaped. The basic difference in these two approaches was not in prognostics but in the conduct of policies. We too would have preferred gradual, a step by step approach, but that option was probably not on the table.
Anyhow, the most outstanding feature of the Governor's announcement raising the bank rate was the lack of any reference to the IMF programme and its conditionals and touting it entirely as State Bank's own decision. We wish the government to follow a similar route. Full ownership of a programme is the most important pre-requisite for acceptance of harsh measures inherent in such an arrangement, that should guarantee its success.