ARTICLE: The State Bank of Pakistan (SBP) issued on February 11, 2012 a statement which it calls "monetary policy statement" for the next two months. It has in fact been issuing such a statement regularly for quite some time.
The approach to monetary policy adopted by the SBP, as reflected in the Statement, does not conform to either the legal scope of monetary policy contained in the SBP Act or professional definition of monetary policy available in all the textbooks on money and banking.
The SBP Act commits the SBP "to determine and enforce, in addition to the overall expansion of liquidity, the limit of credit to be extended by the Bank to the federal government, provincial governments and other agencies of the federal and provincial governments for all purposes...." The textbook definition of monetary policy is "the process of managing the money supply to achieve specific goals such as controlling inflation".
The focus of the Statement is not on the SBP's macroeconomic functions to regulation and control money supply/liquidity in the economy, as required above, rather the focus seems to be on micro banking functions of the SBP like daily liquidity management, smooth working of the payment system and minimization of the day to day money market fluctuations. These micro banking functions are very important indeed but the real task of a central bank is macroeconomic in nature. The monetary policy is a key component of macroeconomic policy framework and it ought to play its rightful role in prudent economic management of the country. That task seems to have been abdicated by the SBP.
We all know that money supply and the composition of credit affect the economy in more than one ways and those, in turn, are affected by factors that are usually grouped under three broad headings of private sector, government sector and foreign sector.
The foreign sector represents the net outcome of foreign trade and other international economic transactions captured in changes in the foreign exchange reserves of the country. The SBP can project the outcome of international transactions in the form of an anticipated change in reserves but cannot control them except through its participation in the formulation of the country's macroeconomic policy framework.
Once the anticipated change in the net foreign assets of the banking system is estimated, it is the responsibility of the SBP to determine the safe limit of increase in the net domestic assets of the banking system that is consistent with the desired rate of growth of money supply to achieve the national targets set for economic growth and inflation.
Economic growth is predominantly determined by the private sector and credit availability to the private sector plays a crucial role in facilitating trade and economic activities. Accordingly, the first priority ought to be to meet the genuine credit requirements of the private sector. For this purpose, the SBP has to make a very comprehensive assessment of genuine credit requirements of the private sector in consultation with the representatives of trade, industry and agriculture and ensure its availability.
If the level of the net domestic assets determined on monetary policy considerations is in excess of the estimated genuine credit requirements of the private sector, the SBP can indicate to the government the scope of government borrowing from the banking system to finance its operations, and the government should adhere to the guidelines provided by the SBP for the sake of sound macroeconomic management of the country.
The reason is that the government should be the secondary and not the primary user of credit as it is expected to finance its operations mainly through the mobilisation of tax and non-tax revenue. Pre-emption of bank credit by the government relegating private sector to a secondary position, or pushing up the net domestic assets beyond the safe limits determined by the SBP, would stand in the way of achieving national economic objectives of high economic growth and relative price stability.
It appears that the monetary policy statement of the SBP is based on a reverse approach. It takes government borrowing from the SBP and the commercial banks as something given and beyond the reach of monetary policy. From there it proceeds to explain as to how sluggish growth in private sector credit and depletion of foreign exchange reserves will partly offset the impact of excessive government bank borrowing on money supply. It then limits the monetary policy statement to an announcement of the so-called policy rate, which is one of the instruments of monetary policy and not monetary policy in itself. If the private sector was the main source of money creation, the SBP could use all or any of the instruments of monetary policy, including the policy rate, to affect the cost and availability of credit to the private sector so that the growth in money supply facilitates economic growth without fuelling inflation.
At present, monetary expansion is mainly driven by government borrowing from the SBP and from the commercial banks and not by bank credit to the private sector. For example, the net domestic assets of the banking system increased by Rs449.8 billion during July1, January 27, 2012 as compared with net public sector borrowing (after taking into account the offsetting effect of retirement of credit by public sector enterprises) of Rs450.2 billion. Thus, the entire increase in the net domestic assets was equivalent to net public sector borrowing. In the circumstances, the monetary policy should have focused on controlling government borrowing from the banking system. Unfortunately it does not and more or less accepts government bank borrowing as given and skirts the monetary policy statement around it.
The monetary policy information compendium has some very disturbing monetary statistics that do not even find their way into the Statement. For example, banks' holdings of government securities now stand at 52 percent of the demand and time liabilities. This should scare the SBP both from the point of view of economic management and viability and stability of the banking system. Concentration of credit is harmful and destabilising not only within the private sector but also in the government sector at the expense of the private sector.
There are several other disturbing undercurrents in the SBP thinking as reflected in the Statement. First, it mentions that the main function of the SBP is to ensure liquidity in the banking system that is being dried up by government borrowing. That is not its main function. The main function of the SBP is to control money supply in relation to output growth so that inflation remains in low single digit.
This shift in focus by the SBP amounts to the SBP becoming a willing financier of limitless government borrowing either directly or indirectly. Financing of government operations by the SBP via the commercial banks has the same implications as government borrowing from the SBP. Still worse, it provides an opportunity to commercial banks to make profits by risk-free lending to the government anchored on borrowing from the SBP rather than by undertaking their main task of financial intermediation between savers and borrowers through deposit mobilisation.
Second, the SBP is cheerfully accepting double digit inflation as a norm associating it to non-monetary factors when it rises and explicitly taking credit for "low effective aggregate demand" in the months in which the rate of inflation had fallen. There are leads and lags in the relationship of inflation with money supply, and its full effect on prices is not simultaneous, but more importantly if decline in inflation was due to "low aggregate demand" in a particular period then rise in inflation cannot be disassociated from higher monetary expansion. Inflation is very much a monetary phenomenon in Pakistan driven by excess liquidity generated by expansion in money supply at about six times the rate of growth of GDP in the last four years.
Third, the SBP endorses the patch work approach of the government to economically survive in the next year or so unmindful of the deterioration in the underlying conditions that has been going on for quite some time. The SBP is the central bank of the country in perpetuity, not a political party, and it has to be focused on the fundamentals of the economy that show signs of deterioration all around.
Fourth, the monetary policy statement is exclusively focused on the level of the policy rate divorced from the rate of monetary expansion and its contributory factors. The policy rate may impact the cost of government borrowing but it does not stop it. It is particularly so in the present circumstances in which the SBP is willingly injecting massive liquidity in the banking system to ensure that banks accommodated government requirements for credit. The many changes made in the policy rate in the recent past have had no effect on the growth in money which continued to rise at a steady pace at different levels of policy rate simply because it was driven by government borrowing.
Fifth, monetary policy mainly operates through the balance sheets of the SBP and the commercial banks. To the extent that those balance sheets are manipulated by the government on non-monetary policy considerations, and the SBP has lost control over them, monetary policy becomes impotent and money supply will remain out of the control of the SBP, regardless of the level of policy rate.
The SBP seems to have given up its role as a central bank and opted to let money supply expand at a rate determined by government borrowing form the banking system and changes in foreign exchange reserves, and without having any concern about the demand for, and supply of credit, to the private sector. Moreover, there are reasons to speculate that even the so-called policy rate is announced by the SBP on implicit or explicit instructions of the ministry of finance.
It seems that the role of the SBP has shrunk to that of an accounting firm and of a manager of daily transactions in the money market. However, the excellent statistical and analytical work being done by the middle level staff is worthy of appreciation.
(The writer is , Former Governor, SBP)