The State Bank of Pakistan’s monetary policy has been used as part of the so-called macro stabilization measures over decades, particularly during periods of higher inflation and when Pakistan was under an International Monetary Fund (IMF) programme. This article examines if this policy is based on sound economic theory and evidence of the efficacy of monetary policy to control inflation in developing countries.
The SBP policy rate was 7.5 per cent when the PTI government took over on 18 August 2018. The policy rate saw a cumulative increase of 325 basis points during the following eight months under the then finance minister Asad Umar as Pakistan’s foreign exchange reserves dropped and the country sought financing from China, Saudi Arabia, and the United Emirates while trying to negotiate a deal with the IMF.
The SBP policy rate was 10.75 per cent when Asad Umar resigned on 18 April 2019 and Dr Hafeez Sheikh took over as advisor to the Prime Minister for Finance. Dr Reza Baqir was appointed as the SBP’s head on 4 May 2019 and shocked the markets by increasing the policy rate (see graph) by 250 basis points in just two months to 13.25 per cent, which was the peak level in almost 10 years. As the interest rates peaked, the economic growth hit its worst level since the financial crisis of 2008. Pakistan’s GDP growth during the fiscal year ended 30 June 2019 crashed to 1.9% from 5.5% in the previous year. Nevertheless, the SBP went ahead and increased the policy rate by 250 basis points over just ten weeks around the same time the economic growth had collapsed. The SBP was quick to reverse the sharp hikes when the COVID-19 pandemic hit the world and aggressively start cutting the policy rate in March 2020 and brought it down by 625 basis points in just three months, bringing it back to around the same level when the PTI government took over.
A comparison of the timing of the interest rate changes juxtaposed with inflation data (see Table) makes a curious study. The raw data doesn’t indicate a relationship between the direction of the interest rate moves and the inflation trends. For example, the Consumer Price Inflation (CPI) rate was fairly stable from May 2018 to February 2019 around 6.4 per cent but the SBP’s policy rate saw a cumulative increase of 375 basis points during the same period. One would infer from such sharp moves that the economy was overheating and the inflation was getting out of control but the official data presented a different picture. The economy was slowing down and the inflation was fairly stable.
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Table: Interest Rate and Inflation
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Date of Change in SBP Policy Consumer Price Sensitive Price Real Policy Rate
the Policy Rate Rate (%) Inflation-CPI (%) Inflation-SPI-(%) (Policy minus
CPI) %
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28-May-18 6.50 6.7 2.9 (0.2)
16-Jul-18 7.50 6.7 2.9 0.8
1-Oct-18 8.50 6.5 1.7 2.0
3-Dec-18 10.00 5.4 1.5 4.6
1-Feb-19 10.25 6.8 7.2 3.5
1-Apr-19 10.75 8.3 10.0 2.5
21-May-19 12.25 8.4 9.9 3.9
17-Jul-19 13.25 8.4 8.9 4.9
18-Mar-20 12.50 10.2 11.8 2.3
25-Mar-20 11.00 10.2 11.8 0.8
16-Apr-20 9.00 8.5 9.3 0.5
16-May-20 8.00 8.2 11.0 (0.2)
22-Jun-20 7.00 8.6 11.5 (1.6)
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What transpired then? Some PTI leaders contend that the interest rate was raised based on what they claimed was being demanded by the IMF. The fact that the SBP under Dr Reza Baqir also aggressively increased the policy rate soon after his taking over as the Governor lends some credibility to this claim.
This brings us to the question if the traditional medicine prescribed by the IMF is appropriate for economies such as Pakistan?
Here, I would like to share the highlights of a paper written by three professional economists with the experience of working at institutions such as Goldman Sachs and the World Bank. In a paper titled, “Monetary Transmission in Developing Countries: Evidence from India”, Prachi Mishra, Peter Montiel, Sengupta Rajeswari (2016) maintained that there were strong priori reasons to believe that monetary transmission may be weaker and less reliable in low- than in high-income countries. They argued that while its floating exchange rate gives the India’s central bank (RBI) monetary autonomy, the country’s limited degree of integration with world financial markets and RBI’s interventions in the foreign exchange markets limit the strength of the exchange rate channel of monetary transmission. The country lacks large and liquid secondary markets for debt instruments, as well as a well-functioning stock market. This means that monetary policy effects on aggregate demand would tend to operate primarily through the bank lending channel. Yet the formal banking sector is small and does not intermediate for a large share of the economy. Moreover, there is evidence that not only are the costs of financial intermediation high but also that the banking system may not be very competitive. The presence of all these factors should tend to weaken the process of monetary transmission in India.
Hence, the above study concluded, “we are unable to uncover evidence for any effect of monetary policy shocks on aggregate demand, as recorded either in the industrial production (IIP) gap or the inflation rate. None of these effects is estimated with strong precision, which may reflect either instability in monetary transmission or the limitations of the empirical methodology.”
Pakistan and India have many structural similarities. They both are lower-middle income countries with relatively low penetration of financial sector and limited convertibility of the currencies. Given the above observations about the efficacy of the monetary policy and almost traumatic experience of shock therapy experienced during 2018-20, it is time policy makers re-evaluate the conceptual and practical framework of Pakistan’s monetary policy to make it more evidence-based (such as growth indicators, industrial production) and responsive to the needs of an economy with a small financial sector and weak monetary transmission.
Copyright Business Recorder, 2021
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