The insistence by the State Bank of Pakistan to keep the discount rate at 13.25 percent since 20 July 2019, which implies a two to three percentage point higher lending rate by commercial banks, continues to generate controversy within the productive sectors as well as previous State Bank of Pakistan (SBP) senior staff, including former Governors.
The controversy centres on abandoning the use of core inflation (minus food and petroleum products whose prices are not linked to the discount rate) by the SBP since 6 May 2019, and instead linking it to headline inflation (consumer price index with food and beverage weightage of 36 percent). The question that arises is whether this out of the box thinking is appropriate for Pakistan or not?
The SBP rationale for using core inflation is detailed in SBP Research Bulletin Volume 2 number 2, 2006 where it is argued that "the extreme price changes in the tails of the distributions are considered to be unrepresentative of the underlying inflation trend. These extreme price changes distort the mean rate of inflation, making it a less efficient measure of generalized inflation. Hence, measures of core inflation, which systematically filter out unrepresentative price changes, are more useful to policy makers.....core inflation measures derived from Limited Influence Estimator (LIE) perform better over the estimates based on the more traditional exclusion principle." However, the author acknowledges that "further research may be appropriate to determine more precisely the benefits of using different measures of core inflation in policy analysis. In particular, it may be useful to examine more closely the usefulness of alternative measures in inflation forecasting."
Be that as it may, clearly, SBP and the International Monetary Fund (IMF) team are on the same page with respect to the discount rate. The July 2019 document titled Request for an Extended Arrangement under the Extended Fund Facility uploaded on the IMF website notes that "since May 16, 2019 the SBP has allowed the exchange rate to be market determined. To reduce the risks to inflation and strengthen confidence, monetary policy has been tightened by 150 basis points. Going forward, the SBP might intervene to prevent a possible overshooting or disorderly market conditions while at the same time not suppressing an underlying trend and in a manner consistent with rebuilding reserves." Eight months down the line domestic economic activity remains stifled and the only inflow is "hot" money and that too in short term government tenors, not a desired form of building reserves as country after country has learnt to its cost. However, clearly that appears to be an objective for the SBP with the January 2020 MPC, arguing that "the recent foreign portfolio inflows reflect international investors' improved perceptions of Pakistan's credit worthiness. Such inflows reduce the interest rate on government debt due to the greater demand for government securities, deepen capital markets, and free up domestic banks' resources for lending to the private sector."
Two aspects of Monetary Policy Committee statements need to be highlighted. First the revised headline inflation rate for fiscal year 2018-19 was 7.2 percent (against the budgeted 6 percent) as per the budget documents 2019-20 registering higher than the average at 9.4 percent in March and 9.10 percent in May 2019. The discount rate was raised by 50 basis points to 10.75 percent in April 2019 before Dr Reza Baqir was appointed Governor on 6 May 2019 while the IMF staff level agreement was reached on 12 May 2019. The first post-Baqir MPC statement maintained that the decision to raise rates to 12.25 percent was taken on the back of continuing underlying inflationary pressures, elevated fiscal deficit and in spite of an improvement the current account deficit remained high (it was a prior IMF condition). In other words, the discount rate was upped well above both core inflation (8.5 percent in April) and Consumer Price Index (7.2 percent for the year) on the projected rate of inflation of 13 percent as per the IMF documents and the budget.
On 20 July, the MPC decided to jack up the discount rate by another 100 basis points to 13.25 at a time when headline inflation as per the MPC statement was 8.9 percent in June 2019 well below the discount rate though "it is expected to rise in the near term due to one off impact of adjustment in utility prices and other measures in the FY 20 budged." Utility prices continue to be jacked up reflecting not one off but multiple adjustments in prices though the Khan administration is considering arresting the utility rates till after the budget for next fiscal year.
More baffling was the comment by the July MPC that it "expects average inflation of 11 to 12 percent in fiscal year 2020" - if this is so then why was the rate even higher than the headline inflation? Perhaps because greater credence was placed on the IMF projection of inflation at 13 percent, based on the time bound performance criteria and structural benchmarks agreed with Pakistan's economic team leaders including a market-based exchange rate, a high discount rate and an unrealistic fiscal target of 5.5 trillion rupees.
Secondly, no doubt in deference to increasing pressure from the cabinet on the back of a hue and cry from the general public as prices rose the 28 January 2020 MPC statement advised that "inflation is expected to fall considerably in fiscal year 2020 as the one off effect of some of the recent causes of the recent rise in inflation diminishes" - this was again inaccurate because the rise in utility rates is an ongoing process without any visible improvement in governance in the power sector or Federal Board of Revenue, inaccurate because of sustained mismanagement in assessing the supply and demand situation of staple food items including tomatoes, wheat and sugar, and inaccurate because the stifling of economic activity as a consequence of the rise in discount rate was not taken into account, which in turn has impacted prices.
The MPC statement dated 28 January 2020 notes: "On balance, the SBP's projection for average inflation remained broadly unchanged at 11 - 12 percent for FY20. The MPC also viewed the current monetary policy stance as appropriate to bring inflation down to the medium-term target range of 5 - 7 percent over the next six to eight quarters." The rosy picture was deferred for a year and a half at best two years at most raising concerns amongst the elected members of cabinet that it would erode their support in their constituencies.
In January 2020, the rate of inflation was 14.67 percent and in the event that the government cannot control this rate in the remaining months of the current year discount rate may be further increased. The latest MPC notes that "current inflows comprised only 3.8 percent of total marketable government debt. As such, inflows at current levels represented limited risks." True but departure of hot money, possible over night as other countries learnt at great cost to their economies, would certainly increase the pressure on foreign exchange reserves. The MPC statement also noted that "SBP continues to monitor developments carefully and has more than adequate buffers to manage any outflows in an orderly manner. The MPC noted that monetary policy would continue to be based on the medium-term outlook for inflation." One wonders if an outflow of the 3 billion dollar hot money parked in short term government securities to date would be manageable by the SBP given its total reserves of 11.73 billion dollars as of 17 January 2020.
To conclude, there is a need for the SBP senior management to undertake research on an emergent basis that would provide the rationale for using CPI instead of the core inflation.
Comments
Comments are closed.