An interview with Dr Shamshad Akhtar, former SBP governor 'Macroeconomic stabilization still very vulnerable'

With more than 37 years of experience behind her, Dr Shamshad is no stranger to Pakistan’s economy, nor needs long introductions. Former central bank governor of Pakistan, Dr. Akhtar has served in top positions of multilateral institutions as Vice President of the World Bank, and Special Senior Advisor of the President cum Director General of Asian Development Bank.  Lately she served as the Under-Secretary-General of the United Nations and was UN G20 Sherpa. 

She continues to be engaged on global development agenda and is also the member of Global Advisory Council on the Belt and Road Initiative and ISDB Advisory Board of Innovation Program etc. She is currently wearing a few hats, including the chair of the government’s insurance reform committee, the chair of SSGC board, and the chair of Karandaaz and remains proactive on policy work in economics and finance.

In this interview, BR Research picks her brains on broad economic affairs focusing on macroeconomic policy management, inflation, monetary policy affairs, the so-called hot money, and much awaited move from stabilization to growth. Below are edited transcripts.

BR Research: Some economic observers are questioning the effectiveness of monetary policy at a time when inflation is roaring mainly because of food supply shocks. What are your views on the matter?

Shamshad Akhtar: Inflation is ultimately about buildup of aggregate demand pressures outstripping aggregate supply. Dissecting different categories of inflation helps better understanding of the causative factors of inflation.

But first a word about the core inflation; it is driven by excessive growth in money generation which in Pakistan’s context has traditionally been induced by excessive government borrowing from the central bank given years of imprudent fiscal management. This is largely because tax collections remain low as a proportion of GDP, while public expenditures are higher than government’s earning capacity.   Deficit financing is a major contributory factor of core inflation.

Driven by multiple factors, non-core inflation stems from disruptions in food markets because of weather and other seasonal factors and logistics complexities, rising energy and rental prices that together induce inflationary pressures. Core inflation today is close to 8 percent, and other component of prices are high too, reflecting demand pressures. Economy has also witnessed steep exchange rate devaluation and upward revisions in energy prices that have stoked inflation.

To address inflation comprehensively, a coordinated action is critical which must involve lowering of fiscal pressures along with continuous suspension of central bank borrowing. Resolution of food shortages and inefficiencies of utilities is critical to keep the cost of delivery of products and services manageable.  If these areas are not fixed, policy rate may remain high and dampen demand pressures across the board, which is determinantal to both the government as well as the industry whose cost of borrowing has gone up.

Central bank’s policy tools have more impact on core inflation. But I do recall in a gathering of central bank governors, US Fed’s Alan Greenspan making a persuasive case that inflation ultimately is a monetary phenomenon and monetary policy has both first and second order impacts as it dampens demand across the economy curbing all elements of inflation.

BRR: That may be true for developed economies but does the same hold truth for developing economies like Pakistan?

SA:  You are right, one needs to qualify that in developing economies inflationary pressures stem from macroeconomic imbalance, structural distortions and disruptions in agriculture, weak food security planning and mismanagement and malpractices in food supply chains.

Lack of institutional coordination hampers policy making, and execution and the fact that the federal and provincial governments are not reinforcing each other in promoting agriculture development and smoothening product supplies and retail networks. There is also a lot of noise and weaknesses in data collection and reporting, making it difficult to structure effective policy responses.

Furthermore, central bank’s actions need to be calibrated effectively as the monetary policy transmission mechanisms are weak in developing countries. Passing categorical judgement on the country’s monetary policy stance at a specific point in time is difficult.  One should draw comfort, as the central bank(s) have over the years strengthened their research and data as well as analytical capacities, where several variables and behavioral elements are deployed in monetary policymaking to get an effective response.

BRR: But in your time as SBP governor did you think that monetary policy was effective when inflation was mainly driven by food supply shocks?

SA: For brevity, let’s concentrate on present trends in consumer price index (CPI). Few factors need to be kept in perspective in judging adequacy of monetary policy stance going forward.

First, will the continuity of present nominal interest rate ultimately push real interest rate further to a negative territory or anchor inflation – there are mixed views. Second, there are reports that food inflation could come down as seasonal factors dissipate and process of pass through of exchange rate depreciation and demand pressure matures, which will eventually bring non-food inflation down too. Third, what is the central bank’s assessment on inflationary expectations – have these been anchored and curbed? Central bank would know this better.

Judging by trends, NFNE (non-food, non-energy) core inflation is currently hovering around 8-8.5 percent relative to 5.6-6.1 percent in FY17, 5.2-5.8 percent in FY18, and 6.8-7.2 percent in FY19 (period average).  These ranges reflect the differential in urban and rural areas.

In revising CPI base to 2015-2016, Pakistan Bureau of Statistics (PBS) now offers disaggregated urban and rural inflation indices. Ironically, in January 2020 CPI has risen to 14.6 percent with rural CPI hitting 16.3 percent and urban food and rural food reaching 19.3 percent and 23.8 percent, respectively. As seasonality recedes or structural issues are resolved, food inflation could come down. Food has high weightage in the CPI so positive developments in food markets would prompt downward adjustment in overall CPI.

There is, however, a concern whether we have accurate data at hand as market prices of key products are above the PBS survey prices used for the computation of CPI.

BRR: Can you dwell a little more on your comment on reliable measure of inflation.

SA: I will not talk about individual commodity items, but we really need to strengthen PBS in virtually all aspects of economic, social and other statistics. We cannot have right diagnostics or manage effective policymaking unless we have a reliable and timely flow of economic and social statistics. It is paramount that the PBS be upgraded and be an autonomous institution as the central bank and the SECP ought to be. They should have total independence and resources at their disposal, and complete hiring/firing power to uplift their game. There is a lot of emphasis on big data globally, and without data you cannot navigate policies and development.

BRR: Let’s move to formal lending to agriculture sector, and to rural dwellers in general. Both as we know are very small. Then how effective is the monetary policy transmission mechanism in that regard. 

SA: Price pressures in rural areas are food related. The monetary policy mechanism transmission in agriculture/rural areas would be a function of the credit flows to the sector/region. Formal lending to agriculture has grown but it indeed remains below the overall credit requirements and is relatively a smaller proportion of the total credit outstanding, with remaining (almost 40-50 percent) being met by informal sector. When interest rates are high, KIBOR on agriculture loans also increases correspondingly; so to that extent agriculture credit is costlier. It is quite well known that informal lenders charge exorbitant rates to agriculture borrowers, which may go up with credit tightening.

Also impacting the rural dynamics is rising rural inflation, which has overshot urban inflation. It is therefore a matter of concern how inflation is impacting rural population, which accounts for a large proportion of Pakistan’s population that otherwise too experiences high incidence of poverty.

BRR: Do you see that there still exists a monetary hangover even after so many months of monetary tightening?

SA:  Pakistan’s fiscal policy has been for years laxed, and there has been lack of understanding of the detrimental impact of central bank financing.  With the fiscal deficit being high for the last few years and governments higher recourse to central bank borrowing, one does expect lingering inflationary impact of the past policy whose dependence was central bank financing.  In recent months, the government has not borrowed from the central bank, but its recourse to other sources of borrowing has its consequences too, whereas its recourse to some financial engineering to build up buffers to finance budget from other sources would crowd out private sector credit.

BRR: What is your outlook on monetary policy?

SA:   It all depends on how entrenched inflationary pressures and trends are.  Food inflation may come down, if recently announced government subsidies and other interventions/measures are effectively implemented. Inflationary expectations remain high, but core inflation may be steady as the government adheres to its promise of not exploiting the inflationary source of central borrowing. This would allow more space and flexibility for policy rate adjustment.

BRR: But will they really tighten further if inflation remain high?

SA: I doubt given the growing economic and social pain that has hurt growth significantly.  Large scale manufacturing sector is growing at virtually negligible pace and other businesses have been hurt as well. This is accompanied by the usual political noise.  To an extent, the noise reflects lack of recognition of the fact that it’s positive real interest rates that hurt business, and as such the rise in nominal levels should be interpreted with caution.

BRR: What if the IMF demands further interest rate hike?

SA: I am not privy to IMF discussions, but the IMF may rest its case. This is largely because of substantial rise in nominal rates achieved thus far, steep economic contraction, the government’s resolve to stick to zero borrowing from the central bank and its endeavors to address food inflation.   Also, hopefully, stabilization will be pursued with growth-oriented policies as business and people are currently being hurt.

BRR: How much room do we really have on the expenditure side. Also are those ‘unnecessary current expenditure items’ really material amounts given the scale of fiscal deficits?

SA: The federal government must reassess current expenditures and slash it significantly. There is scope for reducing public expenditures and its reorientation to allow for much needed investments in human capital. There is need for resolution of inefficiencies of public sector enterprises and/or privatization and cutting them off the budget reliance or stopping them from aggravating inter-enterprise arears. The government’s consolidation and institutional restructuring is critical too. Efforts are underway in these areas, but process remains slow. It’s been nearly eighteen months and the government has not progressed substantively on either privatization or structure the SOE holding company.

BRR: Let’s move on to other aspects of macroeconomics. Do you see growth on the horizon?   

SA:  Pakistan has great economic potential.  However, the periodic bouts of macroeconomic crisis hurt economy.  Also, the pace and sequence of stabilization without adequate emphasis on growth hurts the prospects of sustainable recovery and development.

The fiscal policy is not delivering. It is not delivering on the revenue side, and it has not adopted an efficient budgetary resource allocation mechanism. Investments in human capital is under-emphasized, inefficient outfits continue being subsidized and move to implement workable solutions to PPP has not surfaced – this could go a long way to alleviate fiscal pressures, while meeting the growing demand for infrastructure.

Stabilization should come with growth-oriented policies. The growth-oriented policy frameworks that are typically supported by the World Bank and ADB sequentially come after the IMF letter of comfort on the adequacy of implementation of macroeconomic program. Generally, governments should take a lead on framing their growth policies so that these leads and lags are avoided.

It’s too early to say, when growth will appear on the horizon as stabilisation is still very vulnerable. The government is working several reform projects related to energy, privatization, capital markets and financial inclusion etc.  It’s yet to be seen how this will unfold, when will these be launched and how long it will take to bear fruits.

The industry on the other hand is very categorical that at this rate of interest, and taxation, and languishing reform they will not be able to move forward. While Pakistan has great industrialists, who have promoted competitive industries, there remains scope for diversification, enhancing capacities, enhancing efficiency and productivity in industrial sector.

BRR: Can you talk a little more on those ‘macroeconomic inconsistencies’ you mentioned?

SA: If you keep on tightening monetary policy and keep fiscal policy rather laxed, then you are not going to achieve the results. My biggest debate with the IMF always is that they always chose the easy way out by prescribing high interest rates rather than serious fiscal reforms.

But it’s not that all blame is to be on the IMF. We negotiated the current IMF programme poorly ourselves by accepting stringent front load conditions. The fault also lies in our political economy; we just don’t want to revisit any serious policy issue or change the laws that in most cases go back to at least a few decades if not the pre-partition era.

With fiscal deficit almost hitting 8 percent, the government will be borrowing from every nook and corner, and eventually either crowd out the private sector or revert to central bank borrowing. They have to reach an agreement with political parties, otherwise they are risking complete derailing of economy.

BRR: You mention stabilization is still vulnerable. Can you spell out the sources of this vulnerability? 

SA: The vulnerability stems from a range of factors. First, execution and implementation reflect lack of consistency and coordination between the fiscal and monetary modules. Monetary policy adjustment has preceded, and it is dampening growth, but fiscal deficit is running high given the mismatch between revenues and expenditure.

We have already discussed the expenditure side. On the taxation side, which is principal source of sustainable public finance flows, Shabbar Zaidi has worked tirelessly on reinstatement of the measures (such as tightening of tax concessions/ incentives and other loopholes) and has put in place a new documentation regime, which will augur well going forward.

However, without a substantial broadening of tax base and shift from indirect to direct taxation that is progressive and strengthening of FBR, tax collection will remain below the original targets. We are not effectively taxing high incomes, properties, real estate and agriculture, and so forth as most remain outside the tax net.  We are not dealing with root cause of the problems and avoiding the terse debates of federal-provincial coordination in agriculture, properties and sales tax. Political resolve is critical to tackle these issues; of course, it requires patience, but a reversal or a stand-off will be damaging.

The second source of vulnerability is the external account where bulk of the improvement has come by import contraction without commensurate effort to lift export base. Third source of vulnerabilities stem from significant buildup of debt-creating flows that have grown faster than the non-debt creating flows.

BRR: Where do you stand on hot money?

SA: Given my work experience across Asian emerging financial markets where I have witnessed financial crisis first-hand, triggered by exchange rate volatilities, short term debts and outflows etc., I have always erred on the side of being conservative. I am not against foreign debt portfolio investments but would much rather have the country catalyze equity flows in present context rather than lure short term foreign debt flows based on carry trade.

Some argue that chances of capital flight of these inflows are low as portfolio investors draw comfort from IMF Program being in place that bounds the country to adhere to medium term macroeconomic stability, Pakistan has moved to market determined exchange rate, and the rules of game for SACRA have been institutionalized etc.

There are also arguments that Pakistan is in a safe zone as the level of debt inflows are thus far only $2.9 billion or so and it is helping improve FX liquidity, which allowed central bank to pick up FX in open market as and when possible without disrupting markets.  These purchases facilitate lowering of the FX Forward Swap book, which is now half of $8 billion observed for some time.

This is all reasonable. But going forward incentives need to be aligned to attract non-debt creating inflows, because our debt liabilities have grown and are unsustainable. It would be more prudent to strength and restore confidence in stock market with emphasis on the equity markets and corporate debt – and it’s encouraging that some work is underway in this area.