The economic policy response to the coronavirus crisis by Pakistan has been significant. On the monetary policy side, the State Bank of Pakistan has taken aggressive action to loosen monetary conditions and provide desperately needed liquidity to businesses as well as easier conditions to export-related industries.SBP has reduced the policy rate by 525 basis points over a two month period to 8%. It has also eased banks' capital conservation buffer from 2.5% to 1.5% enabling banks to have an estimated in new PkR800 billion loanable funds. Along with this, the SBP has reduced Special Cash Reserve Requirement from 10% to 5% for lending against FE-25 foreign currency deposits enabling creation of further PKR 60 billion of loanable funds. In terms of direct cash transfers, the Government has announced that it is disbursing PkR200billion for daily wage earners and PkR144billion for vulnerable families. Put all these together, and we are looking at a potential PKR 1.2 trillion of incremental money into the economy. That is about 2.7% of the nominal GDP of Pakistan.

Additionally, on the fiscal side, the Government is providing funding for wheat procurement, exporters' refunds and subsidised financing for SMEs which is around PKR 500 billion, as well additional funding for utility stores, petroleum relief, electricity and gas bill relief and other funding for poverty reduction programmes, in excess of PKR 250 billion while providing tax relief to various sectors to spur economic activity. This level of economic support is at the upper end of the range compared to many emerging countries in the Asia region.

Multilateral financial institutions have also committed greater support for Pakistan with the IMF approving US$1.4billion of new funding for the country in addition to US$6.0 billion EFF already in place. The World Bank and Asian Development Bank have both committed funding of circa US$1.0 billion each, while several major bi-lateral lenders such as China, Saudi Arabia and the UAE have come to the support of Pakistan through rolling over/extending their funding facilities to the country.

Transparency and good governance will lead to credibility of the programmes

These are all necessary and welcome developments to insulate individuals and businesses from the catastrophic impact of the coronavirus crisis. At the same time, for the credibility and effectiveness of these emergency relief initiatives the regulatory machinery needs to be brought up to speed, its institutional capacity enhanced, especially at the provincial level, non-compliance with legal requirements tackled firmly in an exemplary manner and transparency and good governance in implementation ensured.

These emergency response measures will certainly help avoid a catastrophic collapse in economic activity and ameliorate to some extent the human suffering. The question then is, what longer term measures need to be initiated to bring employment, income and the overall economy on to an even keel and begin the long journey back to growth in the coming 12-24 months?

In order to answer this question, it is useful to step back and take a look at the macro-economic policy mix needed to both protect citizens economically in the immediate term as well as set the ground for longer term employment growth, increased productivity and thus sustainably rising economic activity and per capita income.

The conceptual framework for macroeconomic policy

Of the two major macro policy planks, monetary policy and fiscal policy, the first falls under the ambit of the SBP and has been rightly deployed for immediate protection of citizens' employment and income, continuity of businesses and stability of the financial system. However, the efficacy of monetary policy in terms of its multiplier effect reduces over time and also due to leakages in the transmission mechanism (discussed below).

The theoretical underpinning of most central banks' monetary policy can be traced back to Irving Fisher's equation of exchange, MV=PT or its Cambridge version, M=kPT where,

M = Broad Money Supply (Cash + bank deposits)

V = Velocity of money circulation (how many times a unit of money changes hands in a given period of time

P = Weighted average of all prices of goods and services

T = The sum or total of all transactions of goods and services during that period

k = Demand for cash holding, which is equivalent to 1/V

Thus, MV can be looked upon as a proxy for nominal GDP

The Fisher equation states that if V (V being dependent on people's desire to hold cash and bank balances as proportion of their spending capacity or income) and T remain constant in a given period of time, then an increase in Money Supply must cause an proportional change in Prices and thus nominal GDP.

Transmission Mechanism of Monetary Policy

So how is this supposed to work? In 'monetarist' economists' view, there are three main transmission channels of how monetary policy affects employment and income.

The first channel is bank lending. When the central bank reduces the reserve requirement of banks and reduces its discount or policy rate (the rate at which banks can borrow from the central bank), banks would be incentivized to increase their lending while lower rates will attract more borrowing. Theoretically, this would cause an increase in loan demand by businesses and consumers, raising demand and investment leading to increased economic activity and thus GDP (PT) in a recessionary environment when there is a large output-gap (i.e. the economy's actual output is below its potential output capacity).

The second channel is more indirect and is via what is called the wealth effect. This has now come to be known as 'Quantitative Easing' or QE after G-7 central banks' actions in the aftermath of the global financial crisis of 2007-8. In this scenario, the central bank buys large amounts of government debt, mortgage backed and other securities from the non-banking sector (pension funds, insurance companies and mutual funds - which are basically aggregators of individuals' savings, as well as from corporates). The idea is that as these investors' cash and bank deposit holdings increase beyond their 'normal' requirements, they will redeploy this excess money into more productive, riskier assets such as investing in new and existing businesses via buying equities and debt which will increase the prices of these assets and lower borrowing costs throughout the economy, thus generating employment and income and pushing up GDP growth. This channel has been termed as the portfolio substitution channel.

The third channel is much more unconventional and has often been called 'helicopter money', a term coined by Ben Bernanke, the then Chairman of the Federal Reserve Bank of USA and was actually even espoused by John Maynard Keynes in the aftermath of the Great Depression of 1929-30. This channel is supposed to work by putting money directly into consumers' pockets (or bank accounts), something that is now being done by many governments around the world, to save their citizens from the devastating economic effects of the Covid-19 crisis. With massive unemployment and consequent loss of income for large sections of the population, this direct channel acts as an immediate, short-term solution to prevent mass poverty and potential social upheavals.

However, as the SBP has itself noted, these monetary measures can reduce the worst negative effects of an external shock temporarily. But this not a long term solution. For highly indebted countries like Pakistan, with very low tax to GDP ratio, such monetary measures cannot be indefinite without causing irreparable damage to the economic engine via excessive debt burden, debasement of the currency and danger of high inflation.

Even in the US, where fiscal deficit is set to rise above 10% of GDP this year, the Chairman of the Federal Reserve, Jay Powell recently said, "additional fiscal support could be costly, but worth it if it helps avoid long-term economic damage and leaves us with a stronger recovery. This trade-off is one for our elected representatives, who wield powers of taxation and spending,"

It is therefore imperative that a properly designed, forward looking, multiyear fiscal policy is put in place by the Government to do the heavy lifting of getting the economy on to a sustainable growth path over the medium term - two years hence. For such fiscal policy to succeed it needs to be complimented concurrently with structural reforms, especially the execution capability of the public sector, as well as several key supply side and regulatory reforms.

(To be continued)