Fiscal follies

State Bank of Pakistan's (SBP) latest Monetary Policy Statement (MPS) reflects a realisation that cutting interest rate can't compensate for the rise in a variety of other costs of doing business that arise out of the failure of the state.
Power loadshedding, activity shut down courtesy frequent public protests, pervasive lawlessness, and the rise of extortionists and kidnappers for ransom as a force to be reckoned with, have imposed costs that cannot be compensated by fractional reductions in the interest rate.
Although, lowering of the interest rate (via discount rate cuts) helped revive, albeit slightly, economic activity as indicated by the rise in credit to the private sector during July-December 2012, the key beneficiary thereof was the government that kept borrowing at a progressively lower cost.
The continued drop in SBP's discount rate (450 basis points in the last 18 months) largely failed to help revive economic activities, but provided the IMF the grounds to fault it as a policy supportive of the government's reckless borrowing, at a lower cost every quarter.
The fact that SBP decided against a further cut in its discount rate also reflects a growing realisation that continued slide in returns on savings (outcome of this policy), is something that Pakistan cannot afford; its risk perception has worsened far too much to attract foreign funding.
With Pakistan finding it impossible to attract foreign investment inflows, it has no choice but to raise domestic savings. The fact that during July-December 2012 there was a net outflow of $539 million should leave none in doubt that Pakistan now has to stand on its own feet.
Failure to push up the savings-to-GDP ratio that, for decades, has been well below the required level (21 percent) is the result of the combined failure of Pakistan's banks and its trade bodies; neither realises its role in Pakistan's becoming over-dependent on foreign inflows.
Over the years, banks got used to earning interest rate spreads close to 8 percent with no concern for its deadly effects on the competitiveness of the economy and the long-term consequences it will have for Pakistan-many now surfacing to the banks' frustration.
Trade associations seems unconcerned about self-regulation to check hikes in CPI rooted in corrupt business practices, although the rise in CPI is always part of the logic for interest rate hikes that they detest, but don't realise that low CPI alone can bring down interest rates.
Even in the prevailing circumstances - CPI rising since November 2012 - the Lahore Chamber of Commerce and Industry wanted SBP to cut its discount rate by a hefty 150 basis points. This demand yet again reflects the chambers' denial of the ground realities.
The rational SBP decision not to lower its discount rate caused an odd reaction from the banking sector despite the fact that narrowing of the interest rate corridor from 3 percent to 2.5 percent will afford banks a 0.5 percent higher return on placing their surplus liquidity with the SBP.
The comment was that, in emerging economies this corridor is only 2 percent wide, and in developed economies just 1 percent wide. While banks want global yardsticks to apply in this area, they won't lower their banking spreads which are almost twice the global standard.
Apparently, given banks' craving for earning unfair spreads, SPB opted for a new strategy - lowering the discount rate (thus the banks' lending rates) and imposing a minimum return on saving deposits (bulk of the deposit base), to force banks into lowering their spreads.
Banking sector spread was rationalised but just a bit; from a high of 7.8 percent, its sector-wide weighted average dropped to 6.2 percent. This is one positive outcome of the SBP policy of cutting the discount rate over the past 18 months. But in its latest move, by narrowing the interest rate corridor the SBP showed a soft corner for the banking sector. Banks can now earn a return of 6.5% (not 6%) on placing their surplus liquidity with SBP, and sustain the interest rate spread at 6.2 percent.
While the attitude of the trade association and banks, though unrealistic, can be excused given their desire to earn, the state must exhibit far more in terms of social responsibility. But it was never as much of a weakness of the state as it is at present. The sources of consistently high fiscal deficit and public debt are well known - low tax base, high tax evasion, massive subsidies to loss-making Public Sector Enterprises, and (courtesy the IPPs) an energy sector that was rendered excessively dependent on imported furnace oil.
According to the SBP, due to continuous increase in short term public borrowings the share of interest payments in current expenditures has risen sharply mandating comprehensive initiatives to make the fiscal position sustainable, and restore macroeconomic stability.
But no such initiative is on the cards. SBP's concern is that in the first half of FY13, federal tax collection has grown by just 8.8 percent though, to meet its target, it must grow by 35 percent. This performance is worse than that of the past 10 years when the average annual rise in tax revenue was 17 percent.
Without expanding the tax base to brings all the sectors into the net, fiscal deficit will only expand, and with it the need to borrow and go on violating the Fiscal Responsibility Act 2005. Given its 25 percent annual rise since July 2009, public debt could double by FY15.
According to the SBP "the two main challenges are, managing the balance of payment position, and containing the resurgence of inflationary pressures", because a volatile foreign exchange market will have implications for inflation and for all its economic and social consequences.
SBP had been intervening in the exchange market to ensure exchange rate stability, but only a consistent rise in official exchange reserves can ensure rate stability, not SBP interventions; this mandates economic and political stability to improve Pakistan's exports and country risk perception.
SBP has explicitly highlighted the threats we face; it is up to the administrators of the state to take remedial steps - expenditure cuts and increased tax collection - neither administrators' priority in an election year, which reflects the colours of democracy "Pakistani brand".
Just one shade thereof is that, since July 2008, private fixed investment contracted by 9.4 percent while the annual population growth rate exceeded 2 percent. Yet the coalition partners want to be re-elected although their conduct shows concern over suicidal economic trends. Politicians just bury economic issues under the ground not realising that these issues grow up into big trees, of which each branch becomes a lethal side-effect of those issues.