SBP: The challenges ahead

The direction of monetary policy that is to be set by the State Bank's Central Board of Directors after every two months has become fairly predictable due to the generally known behaviour of variables that are usually taken into account in its formulation. Therefore, it was no surprise when the SBP announced its decision to keep the policy rate unchanged at 14 percent on 26th March, 2011 for the next two months.
Almost all the analysts were unanimous in their forecast that there will be no change in the monetary stance this time due to improvement in current account of the country, restrained government borrowings from the banking system and easing of inflationary pressures to a certain extent. Money market was also behaving in the same fashion as indicated by the T-Bills and other rates. Justifying its decision not to change the policy rate at this stage the State Bank also alluded to similar positive developments like favourable external account position and relatively disciplined government borrowings that had abated immediate risks to macroeconomic stability, at least for the next two months.
The real importance of monetary policy statement this time, in our view, lies not in its decision not to disturb the status quo ante but in highlighting a comprehensive list of challenges which, if not properly tackled, could be very risky for the economy and also complicate the task of monetary policy formulation in future. The State Bank has stressed the point in no uncertain terms that "the focus must remain on addressing the structural fiscal weaknesses and reducing inflation to provide a sound platform for sustainable economic recovery in FY12". Admitting that some measures have been announced to contain the fiscal deficit and inflation has eased somewhat, more work was still required to build on these initial efforts by maintaining progress on comprehensive tax reforms, transparent rationalisation of subsidies and the development of a forward-looking debt management strategy.
These measures could check the government borrowings from the banking system and create more space for the private sector, thereby supporting the utilisation and expansion of economy's productive capacity. "Initiation of these reforms has become critical since private and public investments are falling while total debt is rising sharply and expectations of high inflation are becoming entrenched". Sensing stiff resistance to these efforts, the State Bank has, however, cautioned that "this will require support from across the political divide and from other state and civil society institutions to ensure their smooth implementation".
The State Bank also seems to be very apprehensive about certain other issues and developments. It says that though the inflation rate has decelerated somewhat in the recent past, its future path was contingent upon the policy stance adopted with respect to the size of pass-through of high international prices to the domestic market, adjustment in electricity prices and the impact of the recent removal of GST exemptions.
The recently announced tax measures, estimated to raise approximately Rs 53 billion in the remaining months of FY11 and cut in planned development expenditures, may reduce fiscal deficit to some extent during the current year but improvement in the fiscal position on a sustainable basis would require these efforts to be consolidated further. On the financing side, if targeted funds were not received from external sources, there was a risk of substantial government borrowings from the banking system and the consequent rise in public debt with a considerable short-term maturity profile combined with reduced availability of bank credit for the private sector at higher interest rates would create challenges for monetary management in terms of striking a balance between containing inflation and promoting economic growth.
So far as the external sector was concerned, the growing uncertainty in the global economic environment due to popular uprisings in the Middle East and North Africa (MENA) and unprecedented damage to the Japanese economy could contribute to high import prices, particularly of oil, and influence the flow of remittances to Pakistan. All of this could mean growing risks to the economy, and the urgent need for the authorities to attend to the structural issues at hand.
We feel that prognosis of the State Bank as well as its increased emphasis on adverse developments in certain other important areas of the economy is appropriate to the situation as monetary policy cannot be made in isolation and these developments have, of late, tended to dominate the scene. It is more than evident that structural weaknesses of the economy have to be addressed, especially on the fiscal front, without losing more time if increasing risks to the economy have to be minimised and growth has to be revived.
The financing requirements for the budget as well as for non-budgetary borrowings for the procurement of commodities and addressing the circular debt issue are presently so massive that private sector is usually deprived of its genuine credit needs and has to pay a higher cost for its loan requirements. This stifles investment and growth, reduces employment opportunities, enhances poverty and is also a major reason for the continued tight monetary stance of the State Bank.
Unfortunately, however, most of the recent efforts of the government to raise revenues through various measures in order to reduce fiscal deficit to the desired level have faced stiff resistance and been generally thwarted. The imposition of RGST does not seem to be possible anymore, the impact of the rise in international oil prices cannot be fully passed on to the domestic market, energy tariffs cannot be increased to the extent to eliminate the element of subsidies and circular debt continues to haunt the government due to lack of fiscal space.
In fact, the situation has deteriorated to an extent that the government's back is now to the wall and it frequently bows down to the pressure of political opponents, coalition partners and vested interests whenever they decide to mount a resistance. Only a few days back, it had to take the unilateral route of presidential ordinances to meet international commitments for tax reforms under the IMF pressure.
The step envisaged Rs 53 billion of additional taxes on income, imports, agriculture and domestic sales of export-oriented items and was obviously taken after having failed earlier to introduce RGST and other tax mobilisation measures through parliament. Most of the political parties rejected it instantly and termed the move as a violation of the Constitution.
The pressure from the textile sector was especially so strong that the FBR had to amend the relevant SRO along with withdrawal of 2.5 percent special excise duty on textile sector, continuation of zero-rating for exporters, reduced rate of 6 percent to be charged at yarn stage and 4 percent on dyed fabrics for unregistered persons. Obviously, such pressure tactics do not advance the cause of fiscal discipline.
The time has come to cooperate fully with the tax mobilisation efforts of the government or propose practical alternative measures, eliminate waste and corruption, ensure equity in taxation and enable the country to stand independently and absorb the exogenous shocks in an honourable manner. The State Bank has identified the challenges that need to be attended to urgently, failing which, the economy of the country would continue to face added risks and the prospects for welfare of its people would continue to diminish overtime. Even the sovereignty of the state could be at stake if we continue to depend on outside sources of finance to pay our bills.
While there could hardly be any argument against the above prognosis, the State Bank itself could contribute to the prospects and taxpaying potential of the economy by increasing the savings rate through narrowing the spread between lending and deposit rates which, at present, is very high compared to international standards. Given the high rate of inflation and very low return on deposits, there is hardly any temptation to save at the moment. Also, the State Bank is perceived to be soft on the issue of written-off loans which could affect the credit creating capacity of the banks. It was only with the nudging of the Supreme Court that it was constrained to play a more active role in this regard.