MPS: realistic policy analysis

As expected by most of the analysts, the State Bank of Pakistan has decided to keep the policy rate unchanged at 9.5 percent for the next two months. Unlike the Annual Report FY2012, SBP, in its monetary policy statement, decided not to mince words about the deterioration of monetary aggregates and also did not hold back in elaborating the reasons for its decision in greater detail and with a lot of objectivity.
The message conveyed through the MPS is that the behaviour of variables impacting monetary policy is so depressing that the SBP cannot even think about lowering the policy rate any further. The focus is, of course, on strengthening of inflationary expectations, weakening of external sector account and rapidly deteriorating fiscal position and the government's increasing reliance on the banking system to finance the budget deficit which, in turn, is reducing flow of credit to the private sector, constraining investment and undermining growth prospects. According to this MPS, CPI inflation had come down till November, 2012 but has increased since then, current account had posted a surplus during H1-FY13 but foreign exchange reserves have declined predominantly due to IMF repayments and the fiscal deficit is expected to miss the budgeted target by a wide margin. The SBP has lowered the policy rate by 450 basis points over the last 18 months but it is difficult to continue with the same monetary policy stance in the wake of rising risks to macroeconomic stability and in the absence of structural reforms.
The main challenges, from SBP's point of view, are managing the balance of payments position and containing the resurgence of inflationary pressures. The fundamental weakness in the balance of payments is the continuous decline in the net capital and financial flows together with further repayments of dollar 1.6 billion of IMF loan in the remaining five months of FY13 and dollar 3.12 billion in FY14. Volatility in the foreign exchange marked due to these factors could have implications for the inflation outlook. Only a consistent increase in foreign exchange reserves, therefore, could ensure stability in the market. High growth in monetary aggregates driven primarily by fiscal borrowings and upward adjustment in administered prices are also major risks to medium term inflation outlook. While fiscal borrowings from the scheduled banks for budgetary support have grown by an average of 60 percent over the last four years, growth in credit to private businesses just averaged 4 percent during the same period. The inability of the government to keep fiscal borrowings at zero from the State Bank during Q2-FY13 as required under the law was a "contravention of the SBP Act and an important factor behind an imperfect control over inflation expectations by the SBP". The main reason for large borrowing requirements by the government is the structurally high fiscal deficit. The sources of consistently high fiscal deficit are low tax base and rampant evasion together with subsidies to loss-making State-Owned Enterprises (SOEs) and the energy sector. Besides, continuous rise in short-term borrowings at a very rapid pace is increasing the share of interest payments in current expenditures. Comprehensive initiatives are required to make the fiscal position sustainable and restore macro-economic stability. In view of the prevailing macro-economic conditions, Central Board of Directors of the SBP decided to maintain the policy rate at the existing level of 9.5 percent. However, with the objective to improve transmission mechanism and bring more transparency, existing width of the interest rate corridor was reduced from 300 bps to 250bps. This narrowing is good for the banks, to the extent that it raises the floor SBP will pay on overnight fund placements by them.
The business community in general and other borrowers are totally disinterested in SBP policy rate as they have their eyes on election uncertainties. But we feel that the Central Board of SBP has taken a very realistic view of the situation and not shied away from revealing the facts on the ground and has decided not to become a party to growing political uncertainty in the country. SBP had reduced the policy rate by a significant margin in the past 18 months but there was no compelling reason or justification to continue with the same policy stance in the coming months. A special aspect of the MPS this time is its frankness in telling the truth about the factors that have determined the direction of monetary policy stance of the SBP. In the recent past deteriorating aggregates given in the MPS did not justify SBP decision of a rate cut. Those who have been arguing that the monetary policy should be eased further because of deceleration in the rate of inflation in the past few months have been told very clearly that it is only a temporary phenomenon. Containment of inflationary pressures in the medium-term has in fact become a formidable challenge due to rapidly increasing liquidity in the economy caused by excessive government borrowings from the banking system and a sluggish growth which resulted in a situation where rising level of liquidity is chasing either shrinking or stagnating level of available goods and services in the economy. SBP has quite rightly emphasised that it is not possible to maintain lending rates on a lasting basis until and unless country's fiscal position improves and the impediments towards growth such as a declining investment, acute energy shortages and a worsening law and order situation are not addressed. The SBP has also highlighted, if the present drift is not reversed, that it would not be easy to manage the external sector properly and ensure its solvency. The deficit in the current account is a huge challenge due to a decline in net financial inflows and the huge repayments to the IMF in the coming months that cannot be avoided. One way to ease the pressure on the balance of payments (BoP) is to negotiate another programme with the IMF. But both SBP and the technocrats in the Ministry of Finance have failed to get a political decision in the affirmative and have also not engaged the Fund staff sufficiently on a different programme, which could result in putting this country on a sustainable growth path. Traditional upfront conditions of the IMF could be very frustrating for the public and shift their loyalties to other parties near the election time. As for the deteriorating fiscal position, it is necessary for the SBP to advise the government to expand the tax base, curb tax evasion, improve energy situation and eliminate or at least reduce subsidies to the energy sector. However, the political will in the government to proceed in the desired direction is missing due to a perceived negative impact on election prospects of the party in power. Keeping all these factors in view, there was no alternative for the State Bank but to maintain a tight monetary stance to alleviate inflationary expectations. We apprehend that if the current trends continue and the country is forced to enter into an IMF programme in the next few months, which is very likely, the SBP may even be constrained to increase the policy rate again.
However, while appreciating the present monetary policy stance, it needs to be remembered that the State Bank is on horns of a dilemma at this juncture so far as government borrowings from the SBP are concerned. It has clearly conveyed to the government in the MPS that these borrowings during the quarter ended December, 2013 were not only a contravention of the SBP Act but an important factor behind an imperfect control over inflationary expectations. In other words, State Bank would not be responsible for excessive inflation if the government does not mend its ways. In a situation like this, it could be easily argued that the FRDL Act and the SBP Act would lose their significance as instruments of financial stability if the government continues to violate them with impunity. In our view, the parliament needs to take serious notice of the situation and bind the executive, whosoever it is, to adhere to the laws of the land or else change the law if it has become non-implementable. Perhaps, linking yearly external borrowing with export/dollar earnings and domestic debt servicing with rupee - tax and non-tax - resources may be a better way for legislators to understand whether or not our finances are heading in right direction.