State Bank of Pakistan (SBP) finds itself in a catch 22 situation. In order to ensure monetary stability, it continues to increase its discount rate but inflationary pressures continue to surge, with the result that it is again forced to enhance its repo rate to achieve the objective of taming inflation.
Such a vicious circle has been going on for the last few years except a brief interval in 2009 when the repo rate was brought down by 2.5 percentage points to 12.5 percent in stages. The latest increase of 50 basis points to 14 percent in policy rate was announced by the State Bank on 29th November, 2010, with a frank admission that inflation is likely to persist at double digit levels during much of FY11 and possibly in FY12 and the SBP's efforts to counterbalance the rapid expansion in reserve money and arrest the rising inflation expectations would require an increase in the Policy rate.
Analysing the reasons for an increase in inflation, the SBP, in its monetary policy statement, stated that "high inflation, at a fundamental level, persists because of money creation in excess of production activity in the economy." Government borrowings of Rs 266 billion till 19th November during the current fiscal year from the SBP had, in particular, stoked expectations of increasing inflation, resulting in high interest rates. Such fiscal expansion was also a fundamental source of high inflation in Pakistan in the past. As such, it would be difficult to bring inflation down unless government borrowings from the SBP were curtailed substantially and kept under control on a sustainable basis.
The State Bank was also categorical about the consequences of such a flawed approach and concluded that "the entire responsibility of tackling macroeconomic problems has been unfairly placed on monetary policy only." It was also pointed out that the burden of monetary tightening was being borne largely by the private sector, "as it gets crowded out by the excess of government borrowings for budgetary purposes and commodity operations, with all its adverse implications for sustainable economic growth."
There seems to be no argument with the logic of the State Bank as it is based on empirical evidence and largely rooted in economic theory but the problem of the lack of resolve is the real impediment to reverse this undesirable process of unrolling government borrowings being followed by higher inflationary pressures and tighter monetary policy. While the remedy to such an unhealthy development in the form of fiscal consolidation is obvious, it is sad to note that the government finds itself unable to break free from this juggernaut. As a matter of fact, intensity of the problem has increased since the announcement of latest monetary policy review. Compared to the government borrowings of Rs 266 billion for budgetary support from the State Bank up to 19 November, 2010 when the last MPS was announced, such borrowings have risen in the subsequent three weeks to stand at Rs 337 billion, or 346 percent higher as against Rs 75.5 billion in the same period last year. Broad money or M2 has registered a growth of 6.24 percent this year as compared to 4.61 percent in the corresponding period of last fiscal year. Inflationary pressures are also getting worse.
The rise in CPI, SPI and WPI in November, 2010 was higher at 15.48 percent, 23.25 percent and 24.68 percent over the same month in 2009 as compared to 10.51 percent, 10.75 percent and 12.46 percent respectively in the corresponding period last year. CPI, SPI and WPI also depicted higher increases of 1.52 percent, 3.79 percent and 3.48 percent in November, 2010 over the previous month as compared to 1.39 percent, 2.49 percent and 2.79 percent respectively in the corresponding month last year.
As suggested by experience, the recent worsening of trends in government borrowings from the State Bank and the rate of inflation could be a precursor for complicating the task of monetary authorities who would feel the compulsion of raising the policy rate further. This is specially so when the chances of raising more revenues are slim, budget deficit is expected to be much higher than envisaged at the beginning of the year or agreed with the IMF and government borrowings from the banking system, particularly from the State Bank, are likely to accelerate in the remaining part of the year. Higher interest rates are supposed to pressurize the government to be more serious in its fiscal affairs and reduce its borrowings in order to contain its debt servicing but the authorities in Pakistan don't seem to care.
In a situation like this, the State Bank has no option but to tighten the monetary policy though everybody is aware of its ill-effects in the form of reduced credit to the private sector, lower investment, sluggish economic activity, job cuts etc. The sad aspect is that the SBP has ample justification to follow such an anti-growth policy till the fiscal management of the government is improved to a level where it could support the objective of price stability in the country. This is, of course, a tough call but, unfortunately, there are no easy alternatives to the present approach which could prove highly risky for the economy in the long run.