A central bank's primary responsibility as per the International Monetary Fund (IMF) is to conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations. Interestingly in 2017-18, when Pakistan was not on an IMF programme, inflation was 6 percent while the rate noted by the IMF in its first mandated quarterly review report was 11.8 percent for the current year.
The 6 billion dollar ongoing Extended Fund Facility (EFF) 39-month programme had originally projected inflation at 13 percent for 2020 with the first review (December 2019) noting that "average Consumer Price Index inflation is projected to decelerate slightly to 11.8 percent in fiscal year 2020 as administrative and energy tariff adjustments are expected to offset the effects from weak domestic demand. Thereafter inflation is expected to converge to SBP's 5 to 7 percent medium term objective, hitting the midpoint by fiscal year 2022." In other words, there is to be no abatement of inflationary pressures till the end of the programme in September 2022.
SBP open market operations (which contribute to money supply in the economy and therefore to inflation) on 9 May 2019 included an offer of 1,269,450 million rupees at 10.70 percent and the next day another 1,921,400 million rupees at the same rate. On 17 May 1,727,750 was offered at 10.70 percent. Two key dates must be noted: the staff level agreement with the IMF was reached on 12 May 2019 with a host of challenging prior conditions while the loan itself was approved by the IMF Board in the first week of July.
Since 17 May, there have been considerably minor offerings by the SBP no doubt reflecting the commitment by Pakistan's economic team leaders that the government would no longer borrow from the SBP - a standard normal IMF condition that was also imposed on Pakistan during 2008 Stand By Arrangement as well as the 2013 EFF programme. What is noteworthy is that neither in 2008 nor in 2013 the then negotiating economic team leaders (led by Shaukat Tarin and Ishaq Dar respectively) engaged in such heavy open market operations at the tail end of negotiations with the IMF team as in May 2019. This could well be because of the scale and extent of domestic borrowing incurred by the Khan administration during its first year (as well as by its predecessors) which then led to a budget deficit of 8.9 percent in 2018-19 not including the (i) circular energy debt rising to 1.7 trillion rupees and (ii) the state owned enterprises accounting for another 1.6 trillion rupee deficit. Be that as it may, there is reason to query the economic team leaders as well as the IMF team as to why such massive unprecedented open market operations were allowed in the month of May 2019.
Open market operations in May 2019 totalled a whopping 4,918,600 million rupees from three operations - an amount less than what was borrowed in January 2019 when Asad Umar was the country's finance minister with four major operations: 1801,300 million rupees (3 January) 1,090,000 million rupees (11 January) 1,285,250 million rupees (18 January) and again on 25 January of 1,066,700 million rupees giving a total of 5,243,250 million rupees. The rate however was 9.95 percent in January 2019 while it was 10.70 percent in May 2019. And therefore the burden on the government for repayment on January 2019 offerings was 531,119 million rupees, at a time when the government had borrowed heavily to meet an escalation in defense requirements, while it was a tad lower at 526,290 million rupees from borrowings in May 2019.
Pakistan's monetary policies (13.25 percent discount rate which has stifled economic activity and an undervalued rupee to the tune of 5 percent in October 2019 which is contributing to inflationary pressures mainly through its impact on domestic price of imported petroleum and products) have repeatedly and publicly been supported by Prime Minister Imran Khan who refuses to consider words of caution by local economists, even those who have multilateral experience some of whom he hand-picked for his advisory council. The Prime Minister's narrative, perhaps instilled by his economic team, is to dismiss all criticism as coming from the 'mafia' opposed to his administration for personal or political gain, and he has been citing Turkey and Egypt as benefiting from high rates of interest. Such comparisons need careful consideration as each economy operates under some unique conditions.
Two observations with respect to Egypt made by the IMF in the fifth and final review dated October 2019 are as follows (with possibly the same fallout in Pakistan in months to come): (i) "core inflation appears to be relatively well anchored, staff supports the Central Bank of Egypt's intention to maintain a restrictive monetary policy stance to ensure that possible second-round effects from fuel price increases are contained. Volatility in food prices continues to present a challenge to bringing inflation down to single digits." The situation after Pakistan's first review is just as disconcerting because food inflation is up to more than 20 percent, the major expenditure item for the poor and vulnerable, and the restrictive monetary policy is negatively impacting on industrial output with a consequent impact on employment opportunities; and (ii) "Exchange rate flexibility remains essential to preserve the gains in real competitiveness since 2016. The elimination of the repatriation mechanism and better enforcement of regulatory rules on open FX positions of banks has helped strengthen the responsiveness of the exchange rate to capital flows, as reflected in the currency appreciation since the beginning of the year. It will be important to ensure that the exchange rate also has flexibility to move downward should portfolio flows reverse." In Pakistan's case time will tell if SBP's overwhelming focus on attracting and keeping hot money in the country would ensure the discount rate or exchange rate has the flexibility to move downward but so far in spite of serious socio-economic fallout of his policies he has convinced the Prime Minister that his approach is appropriate.
Portfolio investment as a component of foreign public investment, debt securities including special US bonds, Eurobonds, FEBCs, DBCs, T-bills and PIBs, as per the SBP website registered an inflow of 1136.8 million dollars July-November 2020 against 0.1 million dollars in the comparable period of the year before. In contrast, portfolio investment as a component of foreign private investment declined in July-November 2020 to 19.5 million dollars against 330.6 million dollars in the comparable period of the year before. In other words, it is not the stock market but the government's debt securities, consisting of foreign portfolio investment inflows, that have risen and they have risen due to the high discount rate. But hot money has a long history of leaving a country at the press of a button, a move that triggered the Asian Financial Crisis of 1997, and reliance on this as a source of investment is foolhardy at best.
Comparisons with Turkey's economy are not relevant as the differences are numerous. In Pakistan the exchange rate has been undervalued since December 2018 and the inflation is around 11.8 percent. Erdogan sacked his central bank governor recently because he refused to reduce the discount rate by 300 basis points to jump-start the economy arguing that a high interest rate raises inflation (at present the rate is 19.756 percent from the earlier 24 percent with the three major ratings agencies warning Erdogan about political interference with Fitch cutting Turkey's sovereign rating further into junk territory). The depreciation of the Turkish lira, responsible for 25 percent of inflation in the country, has stabilized. But Turkey is more integrated into the world economy than Pakistan (a sharp drop since then in the current account deficit - and the broader shift by the US Federal Reserve and European Central Bank to a more accommodative stance - have helped stabilize the lira) and therefore more susceptible to recent foreign policy issues with the US.
Thus in effect, it would not serve Pakistan's economy if a comparison is made with Egypt or Turkey. Inflation is not linked to discount rate adjustment in Pakistan and this is especially so for food inflation which is linked to input costs (and with rupee undervalued fuel costs rise that account for higher transport and energy costs in the country); the over-correction of policies supported by Imran Khan's economic team leaders account for failure of the private sector to award a pay raise commensurate with inflation with a consequent impact on income levels; and last but not least the high discount rate and the inflow of foreign portfolio investment in government debt securities is raising the government's indebtedness which explains why the current account deficit as a percentage of GDP, as highlighted by the IMF mission chief for Pakistan, is not declining and therefore remains a source of concern.
To conclude, there is a need to revisit monetary policies and perhaps the Prime Minister should consider widening his circle of economic advisors.
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