The State Bank of Pakistan is very clear that developments in the first half of the current fiscal and the outlook for the remaining part of the year justify further tightening of the monetary policy. Aggregate demand pressures remain high as both the fiscal and the external current account deficits are likely to be higher than original projections.
The estimated growth of money supply on an annualised basis by 19.2 percent (relative to the 13.7 percent target) underscores the need for tight demand management. According to the MPS, inflationary pressures are likely to build up further, with headline inflation projected in the range of 8.0 percent for 2007-08 or higher by 1.5 percentage points than the target. "In addition to the impact of reserve money growth on core inflation and difficulties in curbing food inflation, inflationary trends are likely to be impacted adversely due to pass-through of increase in international oil prices".
In fact, the State Bank, which in the past used to talk about maintaining a balance between growth and inflation containment is now so much concerned about the emerging inflationary trends that it has openly stated that risks to inflation outweigh the risks to growth in the near future. Faced with such a scenario, further tightening of monetary policy was almost inevitable.
The discount rate or the rate at which the scheduled banks seek temporary accommodation from the central bank has been raised by 0.50 basis points to 10.5 percent, while Cash Reserve Requirement (CRR) has been enhanced by 100 basis points to eight percent for deposits of maximum one year maturity with effect from 1st February, 2008. Deposits of over one year maturity will, however, remain zero rated to incentivize the banks to mobilise long-term deposits. Some relaxations have, nonetheless, been offered to meet the exigencies of the situation.
The State Bank will develop a relief package for various private and public sector enterprises to meet the losses following the events of December 27, 2007. Effective January 1, 2008, the State Bank has already introduced a new Long Term Financing Facility (LTFF) to encourage export growth.
We feel that the monetary policy strategy of the State Bank and the reasons given to justify it in the MPS are quite appropriate to the situation, though the government may feel a little uncomfortable about sharing the blame for indirectly contributing to the increasing inflationary pressures in the economy.
In the past, the State Bank used to be less critical about the government sector's behaviour because its expansionary impact was manageable, but the developments during the current year have left it with no alternative other than almost openly stating, thanks to its autonomous status, that fiscal mismanagement is the real culprit, adding to the country's financial difficulties.
Total tax collections by the FBR during the first half of the current year were only 6.5 percent higher than last year or even lower than the nominal growth in GDP, which is a clear indicator of poor tax mobilisation efforts. The latest available data from the Ministry of Finance for Q1-FY08 indicates a widening fiscal deficit reaching Rs 158.1 billion, which was 82.3 percent higher than that of the corresponding period last year.
Growth in expenditures (by 38 percent) has outpaced the growth in revenues (by 22 percent). Growing requirements for subsidies in the wake of soaring international oil prices, higher interest payments on domestic debt and increased development costs were the main reasons for escalation in expenditures.
Unprecedented dependence on central bank financing was a reflection of growing fiscal imbalance which was likely to induce further inflationary pressures and, unless lowered significantly, would complicate monetary management further. As a short-term measure, the government would do well to reduce its reliance on borrowings from the State Bank and diversify its financing sources. This could be done by offloading government borrowings from the SBP through issuance of PIBs and NSS at a higher level, and introduction of long-awaited Sovereign Shariah Compliant instruments.
Nonetheless, the long-term solution to the basic problem of fiscal imbalance lies in mobilising a much higher level of revenues, commensurate with the current and development expenditure requirements of the country. It is here that the government seems to be failing miserably. The ratio of tax revenues to GDP, which is already dismal, could decline further this year.
The failure of the government to increase the prices of POL products and readjust energy tariffs is increasing the level of subsidies and putting added pressure on the budget. It is obvious that political considerations are overriding the economic imperatives. The previous government, headed by Shaukat Aziz, did not increase the domestic prices of oil products despite its promise to follow a reform agenda, the present caretaker government is not prepared to take the blame of administering the bitter pill of rectifying the previous policy lapse, and the behaviour of incoming government is not hard to predict.
The task of balancing the budget involves harsh policy decisions, but, unfortunately, governments in Pakistan always try to postpone the problem and adopt easy options. It was thus obvious that monetary policy was increasingly becoming hostage to the fiscal policy of the government, and the State Bank had no choice but to tell its part of the story and explain its compulsions.
The good part the existing imbroglio is that even after a profligate fiscal policy, the flow of private sector credit (including credit to the OMCs provided against government guarantees) has not been adversely affected so far and the price pressures are still under control.
The position could still be improved by tightening the monetary policy which the State Bank has announced in the MPS, nudging the government towards the desired direction. Of course, the realignment of monetary stance would evoke criticism from the business community due to higher lending rates in the coming days, but other choices were too risky to be considered. A higher level of liquidity growth due to excessive government borrowings would have either forced the State Bank to undertake much harsher measures later on and choke the flow of private sector credit or let the country face the risk of hyper inflation which would have been destabilising for the economy.
The policy may be eased and the private sector encouraged once the factors threatening monetary stability are under control. The argument that other countries are lowering their interest rates is not relevant to our situation. While they are facing recessionary threats due to contraction in demand and certain other factors, we are experiencing high inflation due to excessive demand in the economy, originating primarily from the government sector.
On the whole, the MPS contains a very accurate analysis of the current monetary situation of the country, and its observations and conclusions should be taken seriously by the fiscal authorities of the government with a view to putting its house in order. Inaction at this stage could lead to serious consequences in the not too distant future.