One of the IMF’s quantitative targets is a ceiling on government borrowing from the central bank. The objective is to avoid the inflationary consequence of central bank borrowing which is supposed to boost demand. The central bank’s Governor has been saying this loud and clear that the conduit of SBP borrowing to the government is to be closed in order to check inflation. That is the right approach. But the problem is that domestic banking system does not have enough liquidity to finance the never-ending government needs.

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With interest rates more than doubling in the past 18 months or so, the government borrowing requirement to service the debt is increasing and that is further piling up the debt. The alternative domestic avenues to finance treasury borrowing are limited and these (such as NSS instruments) may also substitute bank deposits.

In a nutshell, overall domestic capacity is limited and that is not enough to feed the government’s fiscal financing needs. Within domestic banking and non-banking system, the only way to finance it is by flushing more money into the system. One way is to print new money, or the other way is to shift existing stock of government borrowing from the central bank to commercial banks.

The method of shifting SBP stock of government debt to commercial banks is through reverse open market operations. That was the case during heightening borrowing need in FY16-18 when the reverse OMO was used to provide liquidity to commercial banks by central bank to participate in T-Bills and PIB auctions. The method was reversed in FY19, when the debt was transferred back to central bank as government borrowing from SBP increased by over Rs3 trillion in just one year.

But it was not necessarily inflationary. To the extent it was, the action was justified by the fact there was no other option in domestic system. The only way out is to have external financing of government debt or have other external flows to increase supply of rupee in domestic banking system to fill the fiscal appetite. Unfortunately, the net foreign assets remained negative and that further stressed the domestic liquidity.

In the past two months, the new governor has been saying that the SBP borrowing practice will be undone. But the reality so far is quite different. In the recent T-bill auction government fetched Rs2.2 trillion against the maturity of around Rs600 billion. Similarly, higher amount of PIBs is realized versus the maturity. Virtually all the incremental amount is provided by central bank to commercial banks through reverse open market operation, and banks earned roughly 50 bps spread on it by lending to the government.

In the latest OMO operation (on 26th July), Rs1.87 trillion is injected for 7 days at 13.34 percent, and similar amount for 7 days was injected cumulatively on 18th and 19th July. The amount of injection was about half of it in June 2019. And now it is peaking to 2016 levels. It is interesting to see how the trend to continue in weeks and months to come.

The bottom line is that at the moment, the practice which used to be the case in Dar’s time under IMF is back in action. And seeing higher borrowing needs, the OMO injection may be even higher, going forward. The only way to counter is to have foreign flows. IMF report is saying that around $38 billion will unlock during the fund programme and that is why Governor SBP is not concerned on net international reserves targets. If that amount materializes, SBP borrowing could effectively (without the indirect way of OMO injection) be in its limits. Else, OMO injections too will set new records.