Monetary Policy held hostage by fiscal imperatives?

29 Mar, 2010

The State Bank of Pakistan (SBP) seems to be looking up beseechingly; it's earnestly seeking a supportive role from country's fiscal policymakers to help contain inflationary pressures in the economy to enable it to soften its monetary policy stance. And now, without mincing words, a strong case has been made in its Monetary Policy Decision for April and May.
According to the SBP, the key source of uncertainty lies in the weak fiscal position, causing serious implications for the rest of the economy, including the monetary policy. Keeping the fiscal deficit for FY10 within target would be challenging because of security related expenditures and shortfall in revenues. "Partial phasing out of subsidies and reduction in development expenditures helped in containing expenditures but has led to a surge in domestic prices". Similarly, increased PDL receipts have cushioned the lower tax receipts to some extent, but have contributed towards inertia in domestic inflation.
Uncertainty regarding non-tax revenues on account of slow foreign reimbursements and the extent of remaining power sector subsidies is also adding to the fiscal complications. On the financing side, elusive assistance pledged by Friends of Democratic Pakistan (FoDP) is forcing the government to rely on borrowings from the banking system, particularly from the State Bank.
Quasi-fiscal deficit is also becoming quite problematic. With less than expected retirement of credit availed by the government for commodity operations in the past and onset of the new wheat procurement season, pressure would grow on the banking system resources. "Continued borrowings by the PSEs, partly because of the lingering energy sector circular debt, are also straining systemic liquidity". The brunt of poor fiscal management is likely to be borne by the private sector in the form of reduced credit and higher interest rates.
After a low of 8.9 percent in October, 2009, CPI inflation has slipped back to 13.0 percent in February, 2010 and is likely to remain close to 12.0 percent in FY10. However, despite the presence of high inflation, crippling energy shortages and challenging security conditions, domestic economic activity has picked up in recent months. A cumulative growth of 2.4 percent in LSM during July-January, 2010 was particularly encouraging. The balance of payments position has also improved considerably, although recent trends in FDI and workers' remittances need to be monitored closely. However, given the uncertainties pertaining to the fiscal and quasi-fiscal sectors, striking a balance between reducing inflation, ensuring financial stability and supporting economic recovery is becoming difficult. As an upward adjustment in the policy rate runs the risk of impeding nascent recovery while a downward adjustment could fuel an already high inflation, the SBP opted to keep the policy rate unchanged at 12.5 percent in its Central Board meeting on 27th March, 2010.
Although, it may seem somewhat odd but we had also reached the same conclusion in our columns on the day the Board meeting was to be held. This, in our view, was not a mere coincidence but a fair and objective assessment of the prevailing situation. A closer look at the state of country's economy and the SBP document shows that the central bank did not have much of a choice but to keep the present monetary policy unchanged. It had reduced the discount/repo rate to 12.5 percent in the last week of November, 2009 due to a decline in the rate of inflation from a peak of 25 percent to only single digit (8.9 percent) in October, 2009. The apprehensions of a large fiscal deficit that could again trigger inflationary pressures also appeared misplaced at that time due to the strict covenant agreed with the IMF. However, since then, there has been considerable change in ground realities and the State Bank has been forced to change the direction of its monetary policy, and definitely for good reasons. Further easing of monetary policy, it may be recalled, was contingent on further softening of price pressures which does not seem possible at the moment. In fact, inflation outlook is now highly uncertain and to a great extent susceptible to fiscal consolidation efforts of the government that do not seem to be as concerted as dictated by the situation. While tax and non-tax revenues are lagging much behind the targets, expenditure requirements of the government have increased steeply due to war on terror and other non-development expenditures. Reduction in development expenditures was an option to keep the overall fiscal deficit within target but it is hurting both public sector investment and social sector spending which has severe implications for the welfare of the common man and the prospects of economy. Not only is quasi-fiscal deficit becoming too well entrenched, it is on the rise. Larger requirements for commodity operations and Public Sector Enterprises (PSEs), together with worrying levels of circular debt are definitely an important source of financial instability. Phasing out of subsidies and certain external sector developments like increase in international prices of oil are also adding to the inflationary pressures in the economy. In such an environment, there seems to be no alternative for the SBP but to maintain the present tight monetary stance in order to counter inflationary pressures, emanating from fiscal slippages and certain other sources. In fact, if the prices maintain their present upward trend in the months ahead, SBP may be constrained to raise its policy rate and adopt other credit restrictive measures once again.
It is important to highlight that higher fiscal deficits may also adversely affect the growth rate of the economy by diverting a larger part of bank borrowings to the public sector and starving the private sector of its credit needs. This, in turn, would reduce availabilities and add to inflationary impulses in the economy, imparting more rigidity to the monetary policy stance. Fiscal mismanagement may also force the IMF to terminate its present programme with the country which would have highly negative implications for the foreign sector of the economy.
All told, it is high time for the government to contain fiscal deficit within the stipulated targets, revisit its commodity intervention strategy and resolve circular debt issue as early as possible. This is probably the only way to release more resources for revival of economic activity, contain inflationary impulses in the economy and enable the State Bank to ease its monetary policy. Although, there can be no argument about the urgency of such an approach, political leadership of the country does not seem to be prepared to go all the way and undertake the necessary harsh measures to turn the tide and change the thinking of monetary policy-making authority.
The situation, in fact, has reached a point where political expediency is required to be sacrificed at the altar of economic urgency without any further loss of time. Putting off dealing with fiscal problems will only make them worse. The government must learn to tighten its fiscal belt; it must begin to live within its means. A glance at SBP's Monetary Policy Decision clearly explains why a period of prolonged belt-tightening is going to be necessary. During difficult economic times, it often becomes necessary to economise wherever possible. If this is not done, monetary policy of the country may have to carry the burden of fiscal mismanagement.

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