The State Bank of Pakistan (SBP) has proposed amendments in the Fiscal Responsibility and Debt Limitation Act 2005 to abolish automatic monetisation of fiscal deficit. During a presentation by Hamza Ali Malik, Director, SBP Monetary Policy Department, on "Monetary Policy formulation and implementation in Pakistan" at SBP Rawalpindi office on Wednesday, he highlighted key policy actions for restoring macroeconomic stability and sustainable economic growth.
He said that timely, consistent, and co-ordinated implementation of macroeconomic policies is key to restoring macroeconomic stability. Monetary tightening up till March 2009 was essential to reduce demand pressures; needed to be supplemented by fiscal prudence. Automatic monetisation of fiscal deficit should be abolished. To ensure this, amendments in the Fiscal Responsibility and Debt Limitation Act 2005 are required.
To curb budget recourse to SBP financing there is need to now legislate strict limits on central bank borrowings and launch a program to phase out their outstanding stock. Fiscal sustainability is a key to macroeconomic stability, which requires increase in tax-to-GDP ratio; containment in non-productive expenditures; rationalisation of subsidies; public-private partnership.
Improvement in financing mix of fiscal deficit needs development of long-term secondary domestic debt market. This would also help in the development of deep and liquid corporate debt market. He explained in detail the challenges for effective monetary management.
The implementation of an effective monetary policy assumes presence of an adequate transmission mechanism and absence of fiscal dominance. Unlike most countries in the world, there is no prescribed limit on government borrowing from the central bank defined in the SBP Act or the Fiscal Responsibility and Debt Limitation (FRDL) Act 2005. This unrestricted access to central bank borrowing creates numerous problems for the effectiveness of monetary policy.
Apart from causing inflation, it complicates liquidity management, dilutes the monetary policy stance, puts pressure on foreign exchange reserves, and hurts the private sector credit growth. Moreover, it creates a sense of complacency on the part of the fiscal authority that rather than adopting prudent fiscal policy it tends to rely on the easily available funds.
There is a need to enhance monetary and fiscal co-ordination to achieve mutual and desirable macroeconomic goals. This includes sharing of data and information and regular interaction at the highest level to ensure consistency between monetary and fiscal policies. The role of exchange rate in the context of monetary management is not very well understood. There is a general perception that the State Bank is bound to keep the exchange rate at some predefined level, which is not the case.
For an open economy, it is impossible to pursue such an exchange rate policy along with an independent monetary policy and freely mobile capital across the border. Subsidised credit facilities - for instance Export Finance Scheme (EFS) and Long-term Financing Facility (LTFF) - complicate monetary management and in general promote economic inefficiency.
Unlike many developed and developing countries, data on key macroeconomic variables, such as real GDP, is not available on an appropriate frequency in Pakistan. Unquestionable presence and huge size of the 'informal' sector considerably weakens the effectiveness of monetary policy. There is over-reliance on the banking system to channel savings to the eventual investors. A reflection of this is the high banking spread, he added.
Sharing his experience on monetary policy, the SBP Director explained that monetary policy involves central bank's use of policy instruments to influence interest rates and money supply to keep overall prices and financial markets stable. The monetary policy plays a central role in reducing inflation and keeping it at moderate or low levels, broadly termed as price stability.
Overall monetary policy strategy is a crucial element in ensuring financial stability. An expansionary monetary policy can stimulate economic activity only in the short run, that is, when actual output is much below potential and inflation is low. However, it cannot increase the country's capacity to produce goods and services.
The policy has a lasting effect on inflation but only a transient effect on output. The monetary policy is a stabilisation/aggregate demand management policy and can not impact long-term growth potential. About his presentation on the contours of monetary policy framework in Pakistan, he said that the net foreign assets (NFA) and the net domestic assets (NDA) of the banking system are the two major components of M2.
The NFA is essentially determined by developments in the balance of payments and reserve accumulation/depletion. The NDA is composed of the credit extended by the banking system to the government (for budgetary support as well as commodity operations) and the non-government sector (private sector and public sector enterprises) and the (net) other items.
Thus, the projections of equilibrium money growth - SBP's intermediate target - have to be consistent with not only the projections of the external account and announced federal budget, but also the projected inflation path and the likely real GDP outcome. Thus by construct monetary policy formulation is a forward looking phenomenon.
The change in the monetary policy stance is signalled through adjustments in the policy rate. Importantly, not only the current behaviour of economic variables is affected by a monetary policy decision but also the expected path is influenced via many channels.
The changes in the policy rate are complemented by appropriate liquidity management mainly through Open Market Operations (OMOs) and if required changes in the Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also made, he added.
He said that these measures influence interbank and other market interest rates, starting with the overnight money market repo rate, which is the operational target of SBP's monetary policy. The policy rate (SBP's overnight reverse repo rate) serves as the effective ceiling to the money market overnight repo rate, while the rate on the new overnight facility (SBP's repo rate) provides a binding floor to its downward movement.
The effective control of this rate within this corridor through calibrated liquidity management helps in influencing other market interest rates in a desired manner. The resulting changes in market interest rates and their expected path affects the consumption (domestic as well as imported goods consumption) and investment behaviour (domestic and foreign) of economic agents, and other economic variables through a host of channels and thus influences the level of aggregate demand in the economy.
Finally, the adjustment in aggregate demand affects the general price level and thus inflation in the economy. The bottom line is that both the current as well as the expected monetary policy stance are important in influencing the economic behaviour and ensuring price stability.
Highlighting the monetary policy formulation process, Hamza said that the draft of the Monetary Policy Statement (MPS), which summarises all the relevant information, analysis, and projections, is prepared by the Monetary Policy Department of SBP. This draft MPS is circulated among the SBP's senior management, including Governor, to initiate debate and to get their feedback and suggestions. The senior management discusses the policy proposals based on the analysis in the draft MPS to build consensus on the appropriate monetary policy stance.
After discussion and finalisation of the proposed policy measures, draft MPS is presented in the subcommittee of the SBP's Central Board of Directors - the Monetary Policy Committee (MPC). Following approval from the sub-committee, the same is presented in the meeting of the SBP's Central Board of Directors for its final approval. Later, the Governor usually holds a press conference and announces the policy to the general public. SBP staff and Governor then give interviews on the media to explain the policy stance further.
Regarding Saving-Investment or Aggregate Demand-Supply gap, he said that the widening saving-investment gap is the root cause of current economic distress. If a country invests more than it saves (or consumes more than it produces), it needs to finance this gap through foreign savings (or by running external current account deficit). The presence of a large external current account deficit coupled with a fall in foreign savings leads to an 'unsustainable' situation, drawdown of reserves, and could lead to insolvency.
The persistence of a wide savings-investment gap essentially indicates structural weaknesses of low national savings that are inadequate to meet the investment requirements of a growing economy. Boosting national savings requires committed structural changes while political stability and improvement in the law and order situation is required to make foreign investment lucrative, he added.
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