It was not a secret that the State Bank of Pakistan (SBP) was going to ease the monetary policy of the country. Basing their argument mainly on a consistent decline in the inflation rate, its top officials had been hinting at such a possibility in the recent past. However, the cut in discount rate, announced by the State Bank in its Monetary Policy Statement (MPS) on 15th August, 2009, was less than expected by most of the money-market players.
While some of the pundits were projecting a rate cut of around 2.5 percent, the State Bank chose to reduce the policy rate by only one percentage point to 13.0 percent and justified its stance through a detailed analysis of the latest trends in the economy. The MPS states that on the positive side, "continued implementation of the macroeconomic stabilisation programme is showing improvements in key economic indicators".
CPI inflation continues to fall, government borrowings from the State Bank remain within the quarterly limits and foreign exchange reserves of the country have shown an upward trend. These positive indicators reflect a contraction in aggregate demand, fiscal consolidation and an improved balance of payments position. Consistent with the strengthening of these fundamentals, "interbank money market is functioning smoothly, foreign exchange market is exhibiting stability and deposit growth in the banking system has picked up".
In line with the reduction in fiscal and external current account deficits, the growth in domestic aggregate demand fell to 0.6 percent in FY09, compared to 3.6 percent in the previous year and the saving-investment gap narrowed by 3.1 percentage points. A projected average inflation of around 10 percent for FY10 was, in particular, a vast improvement over the high inflation rate of 20.9 percent during the outgoing year.
However, the State Bank feels that even if some of the positive trends continue, "they do not by themselves herald a sustainable medium-term economic recovery". Likely increases in oil prices and the upward revision of public sector wages may lead to the renewed inflationary pressures. The fiscal position is under substantial pressure, due to higher spending requirements, low economic growth and uncertain external financing sources.
The prospects of global economic recovery and thus, the revival of international investors' sentiment remain weak, leading to uncertainty for Pakistan's balance of payments position. Serious electricity shortages are adversely affecting the potential output of the economy. Apart from capacity issues, circular debt has exacerbated the electricity problem.
While the government had shown a resolve to address these issues, the time taken for the adjustment will put pressure on the budget, with consequent repercussions for inflation and thus the monetary policy stance in the future. The additional donor support pledged in Tokyo, in April, 2009, and increased access to IMF resources, provides only a short term respite to the fiscal position.
After analysing the situation from various angles, the MPS concludes that the challenge was "to strike a balance between stabilisation and sustainable recovery in an environment of nascent 'positives' on the one hand, and complex structural 'negatives' on the other". The reduction of the policy rate by 100 basis points was justified on the ground of giving further impetus to the 'positives'.
The State Bank has also tried to strengthen the monetary policy framework by taking certain additional steps this time. It announced that it would review the monetary policy every other month to make it more responsive to the rapidly changing economic conditions. While the January and July policy announcements would be accompanied with a detailed MPS and a press conference, decisions will be communicated through a brief press release, only, on the remaining four occasions.
An independent monetary policy committee (MPC) was being constituted that would have external experts as members, in addition to SBP representatives. With effect from 17th August, the SBP will adopt a new framework for its monetary operations by introducing a 'corridor' for the money market oversight repo rates. While the SBP policy rate will serve as a 'ceiling', the repo rate on the new overnight deposit facility, 300 bps below the policy rate, will provide a binding 'floor'.
The new facility will allow the banks to deposit their surplus funds with the SBP, against T-bills. The introduction of this measure was likely to improve liquidity management, enhance effectiveness of market signalling and foster stability and transparency in the money market operations. Although, the business community of the country would be disappointed by a cautious monetary policy stance of the State Bank, as reflected in a lower cut in the policy rate than expected, yet such an approach is quite appropriate to the situation.
Relative stability in the core indicators of the economy is still tentative and uncertain and there are so many downside risks that any aggressive or premature easing of monetary policy could lead to cause grave consequences. We must understand that the recent deceleration in inflation rate, which is cited as a justification for a large cut in the discount rate, is neither very pronounced nor firmly entrenched.
In fact, even the latest lower CPI inflation at 11.2 percent in July, 2009 was not only much above the global inflation rate and the past trends within the country, in the last few decades, but also quite distressing for the large majority of population. The balance of payments position is still vulnerable due to a combination of domestic structural issues and global factors and external debt sustainability continues to be an important issue.
The biggest constraint in easing monetary policy, however, is the continued pressure on the fiscal position of the country, which has been exacerbated further by insurgency on the western border and increasing expenditures on the IDPs, together with the difficult domestic political environment. Evidently, the monetary policy of the country is increasingly becoming hostage to fiscal inadequacy of the country.
At the time of the completion of the second review of Pakistan's economic performance, under the SBA on 7th August, 2009, the IMF had to grant a waiver for the non-observance of the end-June quantitative performance criteria, on the fiscal deficit, which was missed by an amount equivalent to 0.9 percent of GDP. Warning was also given that "monetary policy should remain vigilant about preventing a re-emergence of inflation.
The relaxation of the fiscal policy stance, electricity tariff increases, and the rebound in oil prices will add to inflationary pressures that monetary policy needs to combat". Taxes collected by the FBR during July, 2009 were also less than the target. Some risk could have been taken by making a higher rate cut, if productivity in the economy would have been robust and higher level of availabilities was in the pipeline to neutralise the impact of a relaxed monetary policy.
Growing electricity shortages, deteriorating law and order situation and decline in foreign investment have, in fact, subdued the productive impulses of the economy, leading to shortages in certain cases. Obviously, if monetary policy does not carry the burden of increasing weaknesses in other areas of the economy, there will be growing threat of financial instability, followed by all the attendant undesirable consequences.
In our view, the State Bank seems to have analysed all the relevant factors and taken a balanced approach to achieve the basic objectives of price stability and revival of growth. To throw caution to the wind would have been imprudent, which the country can ill afford at this stage.
So far as the strengthening of monetary policy framework is concerned, while increasing the frequency of monetary policy decisions and the introduction of a 'corridor' appear to be good ideas, we don't understand the rationale behind the introduction of an independent monetary policy committee (MPC), with external experts, as members in addition to SBP representatives.
Nobody has ever questioned the integrity, or the wisdom, or the competence of the Board of the State Bank, ably supported by the staff of its policymaking departments, for taking the right decisions at the right time. In fact, views of the State Bank have always been respected and the monetary policy of the country has generally been appreciated, both at home and abroad.
It is the failure of fiscal and external sector policies, which has been responsible for most of the ills affecting economy. Also, there will hardly be any specialised monetary economists available in the country who can give the needed input. If the State Bank Governor can identify the needed talent, it could be recruited in the regular cadre. To have another layer of monetary policy formulation could lead to unnecessary and undesirable confusion. Resort to such highly questionable step could radically compromise confidence of the Board.
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