The State Bank of Pakistan says that the effectiveness of monetary tightening is getting diluted due to the high level of government borrowing from the central bank on account of fiscal slippages and unresolved power sector issues.
While raising its policy rate for the third consecutive time by 50 basis points, the SBP has sent a strong signal across that it expects government borrowing from the central bank to persist and as a consequence, inflation is likely to show obstinacy even into the next financial year.
The SBP Act, unless amended, does not provide the central bank with sufficient tools to effectively force the federal government to abandon its borrowing from the SBP over and above the agreed limits. As such, the SBP, even by raising the policy rate, has landed itself in a no-win situation. Raising the borrowing cost only works if the inflation is strictly demand-driven.
In our case, however, it is not. But then doing nothing makes the SBP lose its credibility with the market forces. Its helplessness can be judged from apparent contradiction in its own policy stance. While on one hand it raises the policy rate as part of monetary tightening - simultaneously it has to inject liquidity into the system through open market operations, thereby diluting the impact of the tightening. Why does it have to do so? Because in case it does not resort to liquidity transfusion into the banks, the federal government would end up borrowing from the SBP - which is far more inflationary than borrowing from banks.
But, what happened on November 15, 2010 is profoundly illustrative of the present state of affairs. The federal government's target for the Treasury Bills auction was Rs 136 billion. Bids received from the banks aggregated to hardly Rs 96 billion. The bid-acceptance amount was a mere Rs 40 billion. As a consequence, government borrowing from the central bank was Rs 77 billion.
The cut-off decision of the Debt Management Department of the Ministry of Finance is indeed baffling. A seven basis points hike in the T-bills cut-off would have netted Rs 80/82 billion. On an advice from the World Bank, the Debt Management Department was created under the MoF and given the responsibility to assess the government debt requirements in a more efficient manner.
Until FY 2008, the SBP used to be responsible for the auction cut-off. Its intervention used to create some confusion in the market, as the cut-off was regarded as a monetary signal. The yields on T-bills are a function of liquidity and not meant to be confused with the SBP's policy rate. At present, even the private sector entities caught in the circular debt trap are living week to week with no improvement in sight.
The amendments in the SBP Act now under National Assembly's consideration, among others, put a limit of 10 percent of previous year's revenue collected on government borrowing. As a consequence, the SBP would be empowered to say 'no' to the government demand if borrowing over the limit is not adjusted within 90 days. Will an adequately empowered SBP be able to say 'no' to the federal government demand is a question that only the future can tell. It's needless to say that we can't predict the future but we can make a goal how our future should be.
While feeling sorry for the helplessness of the monetary managers, one tends to shake one's head in disbelief at the failure of the fiscal authorities to make the political leadership of the country realise that without corrective action, both in raising revenue and cutting expenditure, the system is getting choked and the country's sovereignty is under threat.
The magnitude of the economic problem is now much bigger than it was in 2008. Pakistan went for an IMF programme because it desperately needed help to overcome its BoP and C/A deficit problem. Now that we are in the Fund programme and bilateral support is available and despite the help we are getting deeper and deeper into a debt trap as we are simply borrowing for consumption and not investment.
We should not burden the future with unproductive debt. Productive debt needs to be taken when investment is made in infrastructure assets such as transport, energy, education, health, defence, judicial and political systems. The creation and development of these assets usually involves the state as a provider, subsidiser or regulator. All of them have "public good" characteristics.
Unfortunately, however, we are piling up debt for today's consumption. Countries faced with similar economic woes have come up with plans for fiscal amputation. They have been helped by the IMF and bilateral aid givers because they are matching their spending with revenue collection as fast as possible.
Are the politicians in parliament ready to vote for this? This involves both reforming the tax system, amid getting rid of the loss-making public sector entities or white elephant, stuck as leeches to the federal budget. Is the country's elite ready to share the tax burden?
And, are the politicians willing to let go of the power to dole out? The SBP can only give a reply with the monetary tools it holds. The solutions to address the prevailing security and economic conditions lie squarely with the fiscal authorities, ie, political leadership. One must not lose sight of the fact that the central bank does not act alone to cause policy failures in a country.
In Pakistan's case in particular fiscal authorities play a very important role, usually by excessive expansionary policies such as borrowing over the prescribed limits. It is therefore imperative to recall that the sub-committees of US Senate Banking, Housing and Urban Affairs Committee in one of its hearings in 1999, for example, observed.
Observers often lay the blame at the feet of the Central Bank, for pursuing unbridled money growth. From this belief, tying the hands of the monetary authority will keep money growth in check and stabilise and bring down inflation. ...most central banks are not independent of fiscal authorities and so become the "fall guy" for fiscal mismanagement....
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