What exactly does the State Bank do is a question that crops up repeatedly, especially during times when prices are high and the exchange rate appears to be in a freefall. In Pakistan these days, unfortunately, the rate of inflation on a weekly basis is above 20 percent while the rupee has fallen from 62 to a dollar in the first quarter of 2008 to around 80 rupees to a dollar by the end of the calendar year. Some one is not doing their job.
In the words of its latest report the State Bank of Pakistan (SBP) states that "price stability, the primary objective of all central banks, was threatened by one and a half year's developments in world's financial and commodity markets."
The question is what are the tools available to central banks to deal with the rate of inflation? First, open market operations which are defined as buying and selling previously issued government securities or IOUs. If controlling inflationary pressures is the objective then the central bank would opt to sell treasury securities to a firm that deals in them - an amount that is debited from the dealer's account held at his bank. This implies that the banking system has fewer funds to lend which, in turn, leads to a rise in interest rates or accessing credit becomes more expensive. The economy slows down and curbs the rate of inflation.
The second tool available to the central bank is manipulating the reserve requirement which is defined as the percentage of deposits that the bank must keep in its own vaults or with the central bank - a percentage that cannot be onlent. Raising the reserve requirement would therefore reduce lending - an anti-inflationary policy.
And finally the central bank can manipulate the discount rate or the interest it charges banks for short term loans. If the discount rate is raised then inflationary pressures are checked. So what monetary policy tools did the State Bank of Pakistan use as inflationary pressures began to rise in the country from mid 2007 when the international price of oil and commodities skyrocketed to the present when both oil and commodity prices have declined dramatically?
In the first round, according to the State Bank report, policy discount rate was raised by 50 basis points to 10 percent effective 1 August 2007. This, so claims the SBP, "neutralised the impact of monetary overhang created in June 2007 as evident from deceleration in M2 growth during July-October fiscal year 2007."
The report adds that during November to December 2007, the time of the Caretakers and the continuation of Salman Shah as the economic manager supremo of the Musharraf regime, the federal government borrowed 1.78 billion rupees which 'led to a softening of interest rate and acceleration of M2 growth.' In short the Musharraf regime and his economic managers (Shaukat Aziz did not leave the post of prime minister till November 15, 2007) have much explaining to do for the rate of inflation during this time period.
By February 1, 2008 the SBP raised the discount rate by another 50 basis points to 10.5 percent. At this point the SBP also adjusted the cash reserve requirement, another policy tool available to it and increased it by 100 basis points to 8 percent for demand liabilities. The SBP comments that subsidies continued which were funded through 'magnetisation which diluted the desirable impact of monetary tightening.' This too took place when the former regime's Salman Shah was still in his job, which he left on 25 March 2008.
The third round took place during the tenure of the current government on 23 May 2008 and the SBP used all the three monetary policy tools at this time to check inflation: discount rate was raised by 150 basis points to 12 percent, cash reserve requirement was increased by 100 basis points to 9 percent for demand liabilities and the statutory liquidity requirement was raised by 100 basis point to 19 percent. The SBP adds by way of justification of its failure to control inflation that 'government's heavy reliance on borrowing from SBP continued unabated with additional 149.8 billion rupees during May 25 to June 30, 2008.'
And finally the fourth round, this time under International Monetary Fund dictation, as a pre-standby arrangement approval, the SBP, on November 12, 2008 raised discount rate by a hefty 200 basis points to 15 percent.
However the Governor of the SBP also announced that 319 billion rupees would be pumped into the economy to meet exceptional liquidity requirements of the banking system. What were these liquidity requirements?
According to the Governor in her widely reported Press conference at the time "the SBP's new move would not only help in aligning aggregate demand with supply but would also provide room to accommodate the government's financing requirements from commercial banks."
The latter is disturbing because this implies a substantial money injection into the economy to fund government expenditure which will, needless to say, have inflationary implications. Or, in effect, money has been withdrawn from the system with the raising of the basis points, an anti-inflationary measure, while 319 billion rupees is to be released into the economy with obvious inflationary implications.
A further increase in the discount rate, according to the Letter of Intent submitted by the government to the IMF board and a reflection of already agreed conditionalities with the Fund, "will be considered at the time of the monetary policy statement scheduled for end January 2009."
There is no doubt about the fact that both the previous government as well as the present one have been guilty of borrowing amounts from the SBP that were simply not sustainable. It took going on the IMF programme for the government to commit to zero borrowing from the SBP till the next fiscal year. It is also evident that the SBP acted four times this year to contain inflation and that the last action, which essentially was much more contractionary on the one hand than previous actions put together, was expansionary in terms of liquidity injection, on the other hand.
The question that comes to mind is: if the SBP had undertaken more stringent measures to effectively deal with the rate of inflation would we have as high a rate of inflation? The answer is unfortunately in the affirmative: inflation is not only a function of government borrowing but the fact that production declined due to massive loadshedding, cartelization by suppliers of key kitchen items, for example wheat, and dwindling foreign exchange reserves due to high oil import bill and failure of our exports to keep pace with imports. But one thing is certain - it may not have been as high. This lends credence to critics of the SBP who allege it was too little too late.
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