Money Supply, Inflation and
Economic Growth:
Issues in Monetary Management in Pakistan
M. Ashraf Janjua*
Introduction
The experience of the State Bank of Pakistan
(SBP) in conducting the monetary policy of the country over the years comprises
a whole range of regimes. While the overall objectives of monetary policy have
remained the same, policy contents – intermediate targets, choice of
instruments and controls etc. – have varied considerably over the years.
(I) 1948-59
Given the conditions
prevailing in 1948 the SBP adopted a monetarist approach so far as achievement
of price stability was concerned. One of the objectives of money policy was to
develop the various aspects of the financial sector particularly the banking
system. In this context monetary policy gave importance to the asset side of
the banking system. Thus, upto 1960 the bulk of monetary expansion was on
account of credit to the government sector.
In the
early years of the country’s economic history
the size of the private sector
was small and banks were very conservative in lending. Thus, upto 1959-60
lending to the private sector was a
relatively unimportant source of changes in money supply compared with deficit
financing by the public sector.
Table
-1
Rs. Million
|
Period
|
Private Sector
|
Government Sector
|
Other Items
|
Total Bank Credit
|
Foreign Sector
|
Monetary Assets
|
|
1950-51 to 1954-55
|
257.2
- (12.8)
|
1468.0
(73.25)
|
281.5
(14.0)
|
2006.7
(100)
|
-573.0
|
1433.7
|
|
1955-56 to 1959-60
|
724.9
(23.95)
|
1442.6
(70.98)
|
-73.57
(5.07)
|
2094
(100)
|
287.0
|
2381
|
Source: State Bank of Pakistan
The demand for bank credit from the Public Sector emanated from the
following factors:
1) Growing need of
liquidity in the economy.
2) Government’s
heavy expenditure on the development of infrastructure.
3) Pakistan Industrial Development Corporation
(PIDC) was setup to make up for investment in projects where the private sector was reluctant to enter.
4) Funds for commodity
operations.
Given the underdeveloped financial system** including virtually
non-existent money market, the responsibilities of the State Bank during the
early years of its existence (1948–59) went beyond the conventional functions of
a Central Bank. These included rehabilitation of the banking system and
ensuring its growth through helping the setting up of financial institutions,
developing the money market and training bankers.
(II) Monetary
Policy 1960-72
The year 1959-60 marked the beginning of a phase
of liberalization and deregulation of the economy and substantial flow of
resources from abroad. The Government’s liberal economic policies met with an
enthusiastic response from the private sector. Both the expansion in investment
and production entailing liberalization enhanced demand for credit in the
private sector.
With high growth rates of investment and
production as well as large movements in the external accounts, policy changes
were made by the State Bank to keep pace with these developments and adequately
meet the genuine credit needs of the economy. An overview of the monetary and
credit developments during 1959-60 to 1971-72 shows major changes in terms of
policies, rate of expansion in bank credit and its sectoral distribution.
Table-2
Rs. Million
|
Period
|
Private Sector
|
Government Sector
|
Other Items
|
Total Bank Credit
|
Foreign Sector
|
Monetary
|
|
1960-61 to 1964-65
|
4524.4
(81.0)
|
1447.5
(26.0)
|
-383.2
(-7.00)
|
5588.7
(100)
|
-412.7
|
5176
|
|
1965-66 to 1969-70
|
5539.4
(67.0)
|
4223.9
(51.0)
|
-1480.2
(-18.0)
|
8283.1
(100)
|
273.6
|
8557.3
|
|
1970-71
to 1971-72
|
2043.2 (77.0)
|
3573.8 (134.0)
|
-2958.5
(-111.00)
|
2658.5 (100)
|
235.3
|
2893.8
|
Figures in Parenthesis are percentage
share in the total credit
(III) Choice of
Policy Instruments for Monetary Management 1948 – 72
1) Interest Rate
Policy
During
this period interest rate as an instrument of monetary policy was rarely used.
The State Bank was of the view that the effectiveness of interest rate change
in the economy was subject to many constraints. During 1949-50 - 1958-59 bank
credit formed a small percentage of GDP. Therefore, the effects of changes in
the Bank Rate were unlikely to be substantial. Also, it was viewed that other
general credit control weapons would not be effective because of imperfections
in markets. The banking system was not widespread and currency constituted a
pre-dominant part of the Monetary Assets (M2)*.
Even during the price pressure between July, 1956
and June, 1958, the State Bank’s view remained that a higher Bank Rate or
restrictive monetary policy all by itself could not possibly offset the
powerful expansionary impact of government operations because of the limited
role that the Bank Rate played as a determinant of money supply.
Change in the Bank Rate from
3 to 4 % on January 15, 1959
to supplement fiscal policy to check inflationary pressure had no effect on the
level of bank advances and failed to exercise any influence to reduce
consumption.
Up to 1972 the main thrust of
the State Bank policy was based on the belief that any increase in the interest
rate would adversely affect the investment activity. The Bank Rate was changed
twice during this period i.e. from 4 to 5% on 6th June, 1965 as a
part of containing credit expansion in the private sector and from 5 to 6%
after devaluation of the rupee on 11th May, 1972 as a follow up
measure to protect the benefits of devaluation.
Even in 1962-63 when credit to the private sector
had expanded considerably the State Bank introduced the quota system and did
not favor an increase in the Bank Rate because of the Bank’s perceived adverse
implications of such a measure for the country’s economy.
(VI) Regulations of
Deposit and Advances Rates
During this period deposit and advances rates
were also regulated by the SBP.
(V) Quota System
and Cash Reserves Requirements
As a part of containing credit expansion to a
prudent level the State Bank introduced the Quota System on 1st August 1963 .
This was in respect of scheduled bank’s entitlement to borrowing from the State
Bank against government securities. Borrowing in excess of the quota was
subjected to enhanced rate of interest.
Changes in the Reserve Requirements and the
introduction of the Quota System were found to be ineffective in correcting the
monetary situation. Both the government and the private sector continued to
borrow heavily during 1963-64, and Monetary Assets expanded by 16.9% despite a
contractionary influence of the external sector. Earlier, Monetary Assets had
increased by 17.2% during 1962-63.
In
January 1965 all types of borrowing were covered by the quota system including
bank borrowing by the central and provincial governments. Banks’ borrowing
entitlement against government securities was reduced from 50% to 25%.
Borrowing in excess of the quota was subjected to graduated penal rates. Also,
Reserve Requirements of scheduled banks were raised from 5% to 7.5% in two
installments.
Notwithstanding
these measures credit to the private sector continued to expand and the
government’s bank borrowing also increased following the 1965 war. As a result
of a record expansion in Monetary Assets (M2) of Rs. 2036 million during
1965-66, imbalance between demand and supply put pressure on prices which
increased by 5.7% during 1965-66 and 10.3% during the following year.
However,
credit demand from the private sector continued to expand. As a result, in the
middle of 1967 the State Bank increased the Reserve Requirement to 6.25% and
introduced a whole range of selective credit controls.
(VI) Selective Credit Controls
During
1959-72 the State Bank made extensive use of Selective Credit Controls to
achieve the objective of monetary policy. Selective Credit Controls means
action on the part of monetary authorities to control the flow of credit for
particular purposes. Selective credit controls aim at channeling bank credit to
socially desirable and economically useful purposes. As rightly pointed out by
Richard Porter “selective credit controls are less devious and can be asserted
without so many unpalatable side effects; for this reason they have been more
acceptable as a policy tool of the State Bank…….”.
Selective
Credit Controls pre-dominantly consist of changes in minimum margin
requirements to be retained by banks on advances against various commodities,
to various borrowers, ban on advances against selected commodities, margins
against letters of credit etc.
(VII) Monetary Policy and Movements in Prices
1948-72
Broadly speaking, the entire period up to 1971-72 can be
described as a period of relative price stability. The average price increase
during the first Five-Year Plan (1955-56 to 1959-60) was 3.2%, during the
second Five-Year Plan (1960-61 to 1964-65) it was 2.3% and during the third
Five-Year Plan (1965-66 to 1969-70) it was 4.5%. This also included the only
double digit increase in prices of 10.3% during 1966-67 which was the combined
result of excessive monetary expansion during 1962-63 to 1965-66 (the annual
average of 16.5% compared with annual average growth rate of 7.65%), poor food
crops and interruption in the inflow of foreign assistance. The relative price
stability over the years resulted from high growth rates, an average of 6.78%
during the 10 year period between 1960-61 to 1969-70 and increase in the availabilities
because of liberal import policy and deficit on current account. During the two
turbulent years, 1970-71 and 1971-72, prices came under pressure as a combined
result of demand pressure stemming from turbulent conditions and decline in
growth rate to 1.2% during 1970-71 which rose marginally to 2.3% during
1971-72.
The
State Bank authorities constantly monitored the movement in prices for a
possible policy change to contain inflationary pressures. Whenever the Bank
felt necessary, measures were taken to contain demand through credit
management. The State Bank kept two factors in view: The behavior of price
movement in the country was determined by the agriculture sector which was
susceptible to changes in weather conditions, and the pattern of consumption
was changing significantly, particularly in urban and sub-urban areas because
of a rise in per capita income. When the third Five-Year Plan (1965-66 –
1969-70) placed greater emphasis on heavy industries and infrastructure, the
State Bank unified Cash Reserve Requirements (25th July, 1963) and
introduced the Quota System in respect of scheduled banks’ borrowing from the
State Bank against government securities.
The
excessive monetary expansion was mainly accounted for by large scale deficit financing.
The Third Five-Year plan had envisaged that deficit financing in the entire
Plan period would remain within Rs. 1500 million. Actually, deficit financing
during the Third Plan period amounted to Rs. 4350 million, (Rs. 4.35 billion),
though both the growth rate and availability of aid were less than the original
estimates”.
The graph below depicts movements in M2/y ratio
and inflation during 1950-51 and 1971-72. The graph shows that the biggest
price increases always followed a peak in the M2/y ratio, with a
variable time lag.
(VIII) Monetary Policy and Economic Growth
-1948-72
Monetary
policy’s direct contribution to economic growth can be judged from its
achieving the objectives of (i) increasing domestic savings (as a percentage of
GNP), (ii) real investment and (iii) the rate of economic growth including
special schemes to provide credit to otherwise neglected sectors. Indirect
contribution means (i) maintaining relative price and exchange rate stability
that should generate confidence among economic agents (ii) development of
institutional framework for promoting savings and investment (iii) an efficient
payments system and (iv) distribution of credit.
Various
governments during this period set goals and adopted policies to expand exports
in order to increase the import of capital goods and an increase in domestic
savings. Various incentive schemes intended to promote both of these objectives
were implemented from time to time. However, at no time did the government
attempt either to increase public savings significantly by increasing taxation
or to increase private savings by higher interest rates. The government tried
to increase real investment as a share of GNP by means of an import policy that
restricted imports of consumer goods, both by high tariffs and by import
licensing and increase in the share of investment goods (and raw materials for
investment goods industries) in total imports.
A
policy of changing the composition of available goods in favor of investment
goods relative to consumption goods – while at the same time not changing the
composition of demand – would require an increase in the relative prices of
consumer goods.
During the period under
review money supply increased at a rate that was larger than that consistent
with price stability. Also, the government was not willing to let consumer
prices rise and had always attempted to exert some influence on them. Until
1959/60, these attempts took the form of legal price controls and, in the case
of food grains, requisitioning from farmers at fixed prices. With effect from
1959/60, the government relied more on increasing supplies as a means of
holding consumer prices down.
It is obvious that the policy of holding consumer
prices down by meeting any increases in demand at the controlled prices through
imports – and by permitting domestic consumers to bid away potential exports –
was inconsistent with a policy of increasing the domestic savings rate and
increasing the share of investment in GNP.
The following table shows savings ratios in Pakistan
Table-3:
Trends in Domestic Savings
|
Year
|
GDP
|
Domestic
Saving
|
% of
GDP
|
|
1959-60
|
18257
|
2680
|
14.679301
|
|
1960-61
|
20032
|
3073
|
15.340455
|
|
1961-62
|
20919
|
3533
|
16.888953
|
|
1962-63
|
22406
|
4513
|
20.141926
|
|
1963-64
|
25157
|
5762
|
22.904162
|
|
1964-65
|
28669
|
7111
|
24.803795
|
|
1965-66
|
31690
|
6535
|
20.621647
|
|
1966-67
|
36126
|
7465
|
20.663788
|
|
1967-68
|
38985
|
6787
|
17.40926
|
|
1968-69
|
41945
|
6888
|
16.421504
|
|
1969-70
|
48298
|
8290
|
17.164272
|
|
1970-71
|
51273
|
8761
|
17.086966
|
Sharp increase in savings as a percentage of GDP during 1962-63 and
1966-67, a period of high growth rate, was due to liberal imports of capital
goods enjoying a highly preferential exchange rate and high marginal rate of
savings by the Corporate Sector.
The Export Bonus Scheme
(EBS), by virtue of providing preferential exchange rate for the import of
investment goods, encouraged investment and growth. This, combined with inflow
of aid till the 1965 war with India
(IX) Monetary
Policy 1972-88
Monetary policy during this period was
characterized by:
(1)
Creation of National Credit Consultative Council
(NCCC) and Annual Credit Plan, 1972
(2)
Regimes of credit ceilings with effect from
October 1973
(3)
Directed, concessionary and mandatory credit
targets
(4)
Targets for fixed investment and exports
(5)
Control on bank deposits and lending rates
Thus monetary
policy, which prior to 1972 was essentially conducted through an indirect
method of credit control, was now run by fiat. National Credit Consultative
Council (NCCC) and Annual Credit Plan were introduced in 1972. It was realized
in 1972 on the basis of past experience that use would need to be made of more
direct methods of controlling the volume, the cost and allocation of credit in
the economy. Hence a regime of credit ceilings was introduced in October 1973.
In addition, the State Bank prescribed for commercial banks annual mandatory
targets for production loans, tobacco marketing and loans both for production
and development for small farmers. Simultaneously there were protected targets
for fixed investments and refinancing of loans under locally manufactured
machinery (LMM) and agro based activities.
Also subsidized/concessionary loans were given
under various Special Financing
Schemes introduced by the State Bank during 1972-73.
Before 1972 it had emerged that (a) there was
concentration of credit (b) and interlocking of the ownership of assets
structure: industrial enterprises, banking insurance, shipping etc. The Bhutto
Government, as a part of policy objectives to reduce income inequalities and to
bring about a more just and egalitarian social order, introduced a
comprehensive banking reforms program in May 1972. These banking reforms
emphasized two aspects: (1) End of interlocking of banks and industry etc. (2)
distribution of capital to be spread widely. This was recommended because when
a commercial or industrial undertaking has large interest in a bank it manages
to get easy access to credit facilities of the State Bank which would lead to
further concentration of wealth.
(X) Choice of
Policy Instruments - 1972-88
While the credit ceilings regime was by itself
the main instrument of credit management, use was also made of other policy
instruments.
i. The Bank Rate
By 1972, it was realized by the State Bank
authorities that the past policy of not making significant changes in the Bank
Rate, because of its likely adverse impact on demand for credit, needed to be
revisited, despite the fact that changes in the Bank Rate between 1948 and May
11, 1972, generally failed to have the desired effect on credit expansion.
Realizing that availability of bank credit mattered more than its cost, the
Bank authorities became more flexible on the interest rate policy.
On May 11, 1972 , the Bank Rate was also raised from 5 to 6%
accompanying the devaluation decision. Although subsequently the Bank Rate was
gradually raised to 10% and the deposit rates and the lending rates of
scheduled banks were also raised, the rates of credit and monetary expansion
accelerated during this period.
ii. Selective Credit Controls
These were used mainly to (a) direct the flow of
credit to selected sectors and sub-sectors (b) to prevent the build-up of
inventories particularly of commodities of daily use and (c) serve as an
adjunct to import policy.
iii. Statutory Liquidity Ratio SLR
The Statutory Liquidity
Ratio (SLR) was raised from 25% on 1st September, 1967 to 30% on 6th June, 1973 .
It was further raised to 35% on 16th
August, 1973 , to absorb a part of excess liquidity entailing large
scale monetary expansion in the preceding year. But raising the SLR could not
control the overall volume of credit as it could only influence its
distribution between the public and private sectors, or else would result in
crowding out of the private sector if targeted overall credit expansion was
kept unchanged.
(XI) Credit
Planning and Credit Ceilings: An Appraisal
At the macro level, credit
budgeting was, by and large, an effective instrument of monetary policy in
terms of providing adequate liquidity for the development process without
generating unmanageable price increases. Also, credit budgeting was very
helpful in directing bank credit to previously neglected priority sectors of
the economy. However, the experience had shown that the technique of credit
ceilings was not without problems. For one, credit ceilings tended to adversely
affect commercial banks’ incentive to mobilize deposits. In the same context,
credit ceilings also inhibited competition among banks and gave rise to
complications arising from differences in banks’ types of business, size and
current rate of growth. Credit ceilings severely limited a bank’s ability to
respond flexibly to demands of the economy. It was also observed that before
the upward revision of the rate of penalty, some commercial banks were tempted
to violate the credit ceilings as the earnings expected from their credit
operations more than compensated the loss in the form of penalty. Banks also
began to issue guarantees to their clients who could borrow funds from
DFIs/NBFIs against their guarantees.
Not only did credit for budgetary support enjoy
prior claim over all other credit allocations, very often the Government
borrowed excessively from the banking system, resulting in monetary expansion
exceeding the target agreed in the credit plan. During the five years ended
June 1988, government borrowing from the banking system accounted for nearly
55% of increase in monetary assets, including 64.5% during 1987-88.
(XII) Monetary
Policy, Economic Growth and Inflation During 1972-88
This period witnessed a
series of changes in economic management and policies including in particular
financial polices. The Bhutto regime was marked with radical changes like
widespread nationalization – industry, shipping, insurance, education, banks
etc. – and hence the increasing role of the public sector in economic
management. In the absence of both (i) trained cadres for the management of
economic enterprises and (ii) accountability mechanism, together with
intervention in economic affairs by party people and labor unions, as well as
marginalization of the role of the private sector, economic growth was poor and
inflation touched record high levels.
However, during the Bhutto regime sizeable public
investment took place in mega Public Sector Projects. Thus, if during 1974-75
the budget deficit was 10.6% of the GDP, the public sector program was over
10.2% of the GDP. Economic benefits of these heavy investments were largely
reaped by the Zia-ul-Haq regime.
Economic growth during the Zia-ul-Haq period was
quite impressive, partly attributable to the good performance of agriculture –
in no small measure to availability of water and fertilizer - rehabilitation of
private sector and the law and order situation. Also, there was no political
intervention and economic management was essentially in the hands of
experienced bureaucrats.
The table below shows economic growth,
monetary expansion and changes in prices, during 1972-88.
Table-4: Inflationary Gap 1972-1988
(in percentage)
|
End June
|
Consumer Price Index (CPI)
|
Monetary Growth
|
GDP Growth
(fc)
|
Inflationary Gap
|
|
(a)
|
(b)
|
(c)
|
(b-c)
|
|
|
1972
|
4.7
|
3.6
|
2.1
|
1.5
|
|
1973
|
9.7
|
22.7
|
6.7
|
16.0
|
|
1974
|
30.0
|
13.3
|
7.0
|
6.3
|
|
1975
|
26.7
|
7.8
|
3.3
|
4.5
|
|
1976
|
11.7
|
25.9
|
3.4
|
22.5
|
|
1977
|
11.8
|
24.3
|
2.8
|
21.5
|
|
1978
|
7.8
|
23.0
|
7.8
|
15.2
|
|
1979
|
6.6
|
23.5
|
5.6
|
17.9
|
|
1980
|
10.7
|
17.6
|
6.9
|
10.7
|
|
1981
|
12.4
|
13.2
|
6.2
|
7.0
|
|
1982
|
11.1
|
11.4
|
7.6
|
3.8
|
|
1983
|
4.7
|
25.3
|
6.8
|
18.5
|
|
1984
|
7.3
|
11.8
|
4.0
|
7.8
|
|
1985
|
5.7
|
12.6
|
8.7
|
3.9
|
|
1986
|
4.4
|
14.8
|
6.4
|
8.4
|
|
1987
|
3.6
|
13.7
|
5.8
|
7.9
|
|
1988
|
6.3
|
12.3
|
6.4
|
5.9
|
|
Average
|
10.3
|
16.3
|
5.7
|
10.6
|
Monetary Expansion, Economic Growth and Inflation 1972-1988
The table shows that (1) during 1973 and 1976 to 1979
annual monetary growth was over 20% and this is reflected in the increase in
prices. (2) the average growth rate during the Bhutto regime was 4.6% with an
average price increase of 18%. Corresponding figures for the Zia-ul-Haq period
were 6.6% and 7.3% respectively. Apart from the large fiscal deficit during the
Bhutto regime (an average 8.4% of GDP) and heavy bank borrowing, quantum jump
in the unit cost of imports contributed to inflation as a cost-push factor.
One
thing that emerges from the Table is that during this period there is no
monetary overhang; average growth rate of 5.7% over the years and 10.3%
increase in prices give an average of 16% increase in money incomes. This
compares with an average of 16.3% increase in monetary growth. This is despite
the fact that during the Bhutto period cost push factors in the form of
increases in the unit prices of imports together with the devaluation of the
rupee in May 1972, were quite strong.
(XIII) The
Government, the State Bank and Monetary Policy
Since the early 1970s, when banking reforms were
introduced including institutional changes and subsequent nationalization of
banks in 1974, the Government has exercised virtually decisive influence on the
management of monetary policy. However, even before the changes, the rules
provided an effective control of the Government in the use of instruments of
monetary policy. More specifically, reserve requirements of the commercial
banks as well as liquidity requirements, the two important instruments of
monetary policy, could be changed only with the government’s approval.
Very frequently, the actual
budget deficit was larger than the original estimates, mainly because of the
Government’s over-estimation of revenues and under-estimation of expenditure as
well as because of unforeseen developments resulting in additional claims on
Government resources. Borrowing from abroad depended on several imponderables,
while non-bank borrowing, being on tap, varied considerably vis-Ã -vis budget
estimates. An attraction for government borrowing from the banking system was
the sizable subsidy involved. The State Bank was paid a nominal interest of
0.5% on ad hoc Treasury Bills while banks, over the years, got 4.5 to 6% on Treasury
bills on tap. There was no limit on government borrowing from the banking
system. All these features have meant erratic behavior of government’s actual
bank borrowing, both in terms of year to year changes in absolute amount as
well as in terms of actual borrowing vis-Ã -vis original and revised estimates.
Such changes have constituted an element of uncertainty and very often a
leakage in the management of monetary policy.
It is noteworthy that for
most of the period during 1976-88, for which detailed data are available,
Government and Public Sector Enterprises used a great bulk of total bank
credit. During 1975-76 government’s bank borrowing for all purposes at Rs. 5.24
billion together with bank borrowing by Public Sector Enterprises of Rs. 1.76 billion
constituted 80.57% of total credit expansion of Rs. 8.51 billion. This
percentage stood at 79.5 in 1977-78. It showed a sharp decline to 41.7 in
1985-86 and further to 37.6 in 1986-87. For the rest of the years it varied
between 56.7 in 1981-82 and 76.4 in 1979-80.
Table-5: Bank Borrowing
Rs. in billion
|
|
Government
|
Non-Government
|
||
|
|
Target
|
Actual
|
Target
|
Actual
|
|
Bhutto Regime 1972-73 -
1976-77
|
9.17
|
16.69
|
18.87
|
16.35
|
|
Zia-ul-Haque Regime 1978-88
|
64.30
|
105.6
|
142.21
|
162.00
|
|
Total
|
74.47
|
121.85
|
161.08
|
178.35
|
Table-6: Government
Bank Borrowing for Budgetary Support & Commodity Operations (1972-73
-1987-88)
Rs. in billion
|
|
Target
|
Actual
|
|
Budgetary Support
|
43.06
|
104.30
|
|
Commodity Operations
|
14.40
|
21.60
|
(XIV) Quasi Fiscal Deficit
Apart from borrowing from the banking system for
budgeting support, the banking system – both the State Bank and Scheduled banks
– provided resources to Government, both Central and Provincial, to PSEs, as
well as resources and subsidy to government sponsored institutions. This is a quasi-fiscal
deficit, which may comprise the following.
|
i.
Government’s bank borrowing for commodity
operations
|
(stood at Rs. 11.46 billion as of end June 1988)
|
|
ii.
Bank loans to PSEs
|
(stood at end June 1988- 36.12 billion)
|
|
iii.
State Bank lending to development banks and
other institutions
|
(outstanding as of end June 1988 Rs. 34.1 billion)
|
|
iv.
Subsidy involved:
|
|
|
a) Lending
to DFIs / NBFIs
|
Rs. 3.7 billion during 1988
|
|
b) Subsidy
on Lending to government
|
During 1973-88 Rs. 9.43 billion
|
(XV)
Market Based Monetary Management: Reserve Money Programming
Before the introduction of
financial sector reforms State Bank had adopted monetarist approach to monetary
policy. Monetary expansion and credit requirement of the economy were worked
out on the basis of (i) targeted growth rate (ii) inflation target and (iii)
the likely behavior of the foreign sector. Allocation of credit was through
administrative fiat: credit ceilings, credit deposits ratio and several schemes
of directed, mandatory and concerning credit. The process of shifting monetary
policy to indirect, market-based instruments went roughly through four phases.
Within the overall framework of the Annual Credit Plan, the elaborate regime of
credit ceilings introduced in October, 1973 for individual banks to meet the
credit needs of the private sector, and later on of PSEs also, continued till
end-June, 1992, although by this time a number of reform measures had already
been taken to initiate the transition from administrative fiat to a
market-oriented approach. The system of credit ceilings was replaced with the
somewhat flexible system of credit deposit ratio (CDR)[1] with effect from 1st of August, 1992. Various
reforms continued during this phase (1992-93 to 1994-95), culminating in the
abolition of CDR itself on 30th
September, 1995 . This marked the beginning of the third phase
covering the period up to June 2001. Indicative credit targets replaced the CDR
and the main reliance to conduct monetary policy was placed on Open Market
Operations (OMOs)[2]. Subsequently, when the Pak rupee was put on free float
in May 1999 and in the real sense in July, 2000[3], Monetary Policy and Exchange Rate Policy were fully
integrated. This marked the beginning of the fourth and the final stage.
Market based monetary management involved reserve
money programing, the broad objective of which was to develop a framework to
project the desired path for reserve money, which was consistent with the
targeted growth in money (M2) derived from the macro-economic
framework. The reserve money is affected by (a) deposit mobilization, (b)
government cash position, (c) government borrowing requirements, (d) maturity
of existing government debt, (e) reserve requirements and (f) borrowings from
the State Bank. The State Bank has to watch all these variables and attempt
forecasts in order to arrive at a judgment on the level of reserve money that
is consistent with the target of monetary expansion. All this is done within
the framework of the Annual Credit Plan.
(XVI)
Monetary Policy, Prices and Economic Growth 1988-89 - 1998-99
This period is one of transition of monetary
policy management from Credit Ceilings (upto end June 1992), Credit Deposit
Ratio (August 1992 – September 1995) and indicative targets (October 1995 –
Jan. 2001) to reliance of monetary policy on OMOs. Also, this is a period of
political turmoil and substantive policy changes. Political regimes during this
period were more pre-occupied with survival than with medium or long-term
economic policies. A number of interim/caretaker governments undertook important
economic and financial sector reforms, especially during the Wasim
Sajjad-Moinudin Qureshi and Farooq Leghari-Malik Meraj Khalid terms.
Politically elected leadership found it difficult to implement Fund/Bank
conditionalities for fear of losing popular support. As a result, in terms of
growth, the 1990s was described by some analysts as a ‘lost decade’ for Pakistan
In the 1990s the growth rate
tumbled largely because of decline in capital inflows and a number of other
factors[6] including persistent lapses in implementation of
structural reforms and stabilization measures. Thus in terms of economic
growth, the period came to be known as the ‘lost decade’.
The worsening law and order
situation during the 1990s affected not only the security of life, property and
honor of individuals, but it also created difficulties in entering into
contracts and their enforcement. In the wake of internal instability and
judicial lacunas, investors, both domestic and foreign, could not exploit
investment opportunities in the country. Rampant corruption and worsening
standards of governance of almost all national institutions amounted to a prohibitive
cost of doing business in the country.
Withdrawals from foreign currency deposits of
resident Pakistanis were suspended in May, 1998. This antagonized an important
class of investors[8].
In my view the 1990s was not the “lost decade”. In fact
despite a high rate of economic growth, the 1980s was a period of missed
opportunities, and the legacy the economic managers of this period left for
those who followed was not an enviable one. First was the rising fiscal
deficit, the result of a very large increase in government expenditure
(including defense), which left a crushing debt burden on the economy. Second,
if the needed economic reforms to achieve macro balance and competitiveness had
been initiated when the economy was in a relatively strong position it would
have lessened the burden on the economy and the people of undertaking these
reforms when the economy was in a relatively much weaker position.
Juxtaposed to a difficult and trying economic
environment, the 1990s saw a slowing down of economic growth because of shocks
beyond the control of economic managers. There had been large fluctuations and
a decline in cotton production which was persistently hit by pest attacks,
continuing slowing down of remittance inflows, bad weather conditions which
directly affected agricultural production and economic sanctions after Pakistan
Superimposed
over these negatively contributing growth factors were the shortcomings of
economic management in the 1990s, which made matters worse. The foremost among
them was the sequencing and pace of implementation of the economic reforms
program.
Table-7: Macroeconomic Indicators: Actual (%
Growth)
Year
|
GDP
|
Inflation
|
Monetary
Assets
|
Inflationary
Gap
|
|
1988-89
|
6.7
|
10.4
|
7.8
|
1.1
|
|
1989-90
|
7.0
|
6.0
|
17.5
|
10.5
|
|
1990-91
|
3.9
|
12.7
|
17.4
|
13.5
|
|
1991-92
|
3.4
|
10.6
|
26.2
|
22.8
|
|
1992-93
|
2.8
|
9.8
|
17.8
|
15.0
|
|
1993-94
|
4.5
|
11.3
|
18.1
|
13.6
|
|
1994-95
|
5.3
|
13.0
|
17.2
|
11.9
|
|
1995-96
|
4.6
|
10.8
|
13.8
|
9.2
|
|
1996-97
|
1.9
|
11.8
|
12.2
|
10.3
|
|
1997-98
|
3.5
|
7.8
|
14.5
|
11.0
|
|
1998-99
|
4.2
|
5.7
|
6.2
|
2.0
|
|
Average
|
4.3
|
10.0
|
15.3
|
11
|
Monetary Policy, Inflation and Economic Growth (1999/00 to date)
This period has witnessed rapid changes in a
number of areas which posed formidable challenges to the economic managers in
the country. In fact, this period has tested the technical acumen of the
country’s financial managers. In this part of the article these developments as
well as the implications of policy responses are dealt with.
(XVII)
Economic growth
There is visible optimism in the Pakistan
For the last few years the State Bank continued
to pursue a growth accommodating policy stance. Consumer demand materialized as
a result of record level of bank lending to the private sector and consequent
availability of purchasing power. This was the growth engine which the
government used. It was also expected that investments in a number of
industries in LSM would create additional capacity, so that full utilization of
existing capacity does not become a constraint.
All these developments originated in the foreign
sector- building up of foreign exchange reserves entailing inflow of
remittances and reverse capital movements. There were no investment
opportunities to absorb the inflow of capital which resulted in a sharp decline
in the interest rate. This liquidity found its way to real estate, the stock
exchange and liberal lending by banks. These developments and issues stemming
therefrom are discussed under the following headings:
1.
Monetary and Credit developments
2.
Interest rate policy
3.
Inflationary pressures
4.
Political back drop of these developments
5.
Conclusion
6.
Future outlook
(XVIII)
Monetary and Credit developments
The increase in liquidity in recent years has
been immense as shown in the table below:
Table-1: Causative Factors for Monetary Growth
|
|
|
|
|
|
|
|
|
|
|
|
CP1
|
CP2
|
|
Rs.
Bin
|
FY96
|
FY97
|
FY98
|
FY99
|
FY00
|
FY01
|
FY02
|
FY03
|
FY04
|
FY05*
|
FY05
|
FY05
|
|
Government
Sector
|
68.5
|
80.9
|
55.9
|
-74.8
|
78.2
|
-46.7
|
22.2
|
-78.4
|
58.1
|
13.5
|
47
|
65
|
|
- Net
Budgetary Borrowing
|
51.7
|
72.5
|
48.0
|
-75.2
|
40.0
|
-32.3
|
14.3
|
-56.0
|
63.7
|
16.3
|
45
|
60
|
|
- Commercial
banks
|
na
|
na
|
na
|
na
|
-95.1
|
-0.8
|
|
193.3
|
3.7
|
|
|
|
|
- Central
Bank
|
na
|
na
|
na
|
na
|
135.0
|
-31.6
|
|
-249.2
|
60.0
|
143.0
|
|
|
|
- Commodity
Operations
|
5.9
|
5.7
|
10.6
|
3.6
|
40.1
|
-12.5
|
5.3
|
-26.6
|
-8.2
|
-5.1
|
5
|
5
|
|
- Zakat,
Privatization etc.
|
10.9
|
2.8
|
-2.7
|
-3.3
|
-1.8
|
-1.9
|
2.5
|
4.2
|
2.6
|
2.3
|
-8
|
0
|
|
Non-Government
Sector
|
63.4
|
61.9
|
84.2
|
119.2
|
26.0
|
69.2
|
19.0
|
148.5
|
315.4
|
331.3
|
190
|
330
|
|
- Credit
to Private Sector
|
54.8
|
61.1
|
76.3
|
84.1
|
18.1
|
56.4
|
53.0
|
167.7
|
325.2
|
348.7
|
200
|
350
|
|
- (growth
rate%)
|
17.3
|
15.9
|
17.0
|
14.2
|
2.9
|
8.1
|
6.6
|
18.6
|
34.3
|
27.4
|
15.7
|
27.5
|
|
- Credit
to PSEs
|
6.1
|
2.0
|
8.6
|
16.2
|
7.6
|
20.6
|
-19.5
|
-11.6
|
-2.9
|
-11.4
|
-5
|
-15
|
|
- SBP
Credit to NBFIs
|
2.5
|
-1.2
|
-0.7
|
18.9
|
0.4
|
-7.7
|
-14.5
|
-7.6
|
-6.9
|
-6.1
|
-5
|
-5
|
|
Other
Items Net
|
21.1
|
5.2
|
26.8
|
0.3
|
14.5
|
30.9
|
-12.0
|
-61.7
|
-9.2
|
-88.9
|
11
|
65
|
|
Domestic
Credit Expansion
|
152.9
|
147.8
|
167.0
|
44.7
|
118.7
|
53.4
|
29.2
|
8.5
|
364.3
|
255.8
|
30
|
30
|
|
Monetary
Expansion
|
113.9
|
114.6
|
153.1
|
74.2
|
120.1
|
126.0
|
235.3
|
317.4
|
407.9
|
326.6
|
280
|
360
|
|
(%
charge)
|
13.8
|
12.2
|
14.5
|
6.2
|
9.4
|
9.0
|
15.4
|
18.0
|
19.6
|
13.1
|
11.5
|
14.5
|
|
Real
growth (%)
|
6.6
|
1.7
|
3.5
|
4.2
|
3.9
|
1.8
|
3.1
|
5.1
|
6.4
|
|
6.6
|
7.0
|
|
Inflation
(annual avg CPI)
|
10.8
|
11.8
|
7.8
|
5.7
|
3.6
|
4.4
|
3.5
|
3.1
|
4.6
|
|
5.0
|
7.0
|
|
M2
over nominal growth
|
-3.6
|
-1.3
|
3.2
|
-3.7
|
1.9
|
2.8
|
8.8
|
9.8
|
8.6
|
|
|
|
Source: Annual Report FY 03 & Statistical Bulletin August 2004,
SBP* July to April 9, 2005 .
As can be seen from the Table above the rate of
monetary expansion picked up from FY02 and since then total monetary expansion
has been Rs. 1371.9 billion (upto 25th June 2005) and amounted to
90% increase over the stock of money in 2000-01. Credit expansion amounted to
Rs. 371.2 billion between 1st
July 2004 and 25th
June, 2005 . Private sector credit expanded by Rs. 390.3 billion
between 1st July
2003 and 25th
June, 2005 .
Once liquidity is injected into the system it
becomes purchasing power in the hands of economic agents. This purchasing power
keeps changing hands. Thus, as a monetarist would say, the excess purchasing
power does not guarantee sustained increase in aggregate output. A short term
increase in production will be accompanied by rising prices. Hence the view
that money is neutral and inflation is a monetary phenomenon. There is always a
time lag between the injection of liquidity and its manifestation as inflation[9]. The
latest research shows that this time lag is between 18 to 20 months. This aspect of monetary policy has not
received any attention in the State Bank of Pakistan
Also, the recent increase in
prices was nowhere in the calculation of the State Bank. The Bank has been
changing the expected rate of inflation during the current year after every few
months. This clearly shows that the State Bank had not done its homework. When
increase in prices turned out to be beyond the State Bank’s expectation, it had
no alternative to tightening the monetary policy. In its second quarterly
report the Bank acknowledged that the token tightening of monetary policy did
not have any impact on demand for credit by the private sector which upto 2nd
April 2005 amounted to Rs.362 billion, compared with original estimates of
Rs.200 billion and revised estimates of Rs.350 billion for the year as a whole.
In fact despite increase in the interest rate,
though still negative in real terms, the private sector continued to borrow
from the banking system. As of 25th
June 2005 credit in the private sector stood at Rs. 390.3 billion.
The stock market bailout by banks entails a further increase in the private
sector credit over and above normal lending. Full year bank lending to the
private sector may very well be around Rs. 400 billion.
The monetary overhang between FY01 and FY04 was
30%. Even calculated from FY96, the monetary overhang by end of FY04 was 26.5.
As can be seen from the last row in Table-1 the FY05 has absorbed only 1.2% of
this overhang. The rest of the overhang, though not entirely stemming from
credit expansion, will manifest itself sooner or later.
(XIX)
Interest Rate Policy
It was as late as 11th April 2005
that the State Bank was awakened to the need for adjustment in the interest
rate to tighten the liquidity in the economy. Reluctance on the part of the
State Bank to raise the interest rates close to the rate of inflation has been
a major failure of the Bank. The State Bank hesitated for a long time to
tighten monetary policy which could be attributed to the Bank’s (and
government’s) perception that cheap credit is one of the main reasons for
strong growth. Since August 2003 market interest rates became increasingly
negative in real terms. This failure, in the context of excess of liquidity in
the economy, gave rise to many problems. This is despite the fact that the State
Bank’s attention was drawn- more than once and by more than one entity – to the
urgent need to adjust the interest rate. More specifically, with the inflow of
money in the form of Net Foreign Assets (NFA), the State Bank was unable to
stop the slide in the interest rate. An attempt was made to absorb the excess
liquidity through the auctioning of public debt. This was not an effective
method of sterilization and the interest rate declined to a record low level.
This decline in the interest rate was of tremendous advantage to the corporate
sector and to the government in more than one way.
It needs to be mentioned that auctioning of
public debt is not the conventional way of sterilization. Recently, a number of
countries, faced with similar situations, sterilized capital inflows through
OMOs, window guidance (direct control on the credit volume of selected banks)
and / or increased Reserve Requirements.
Sterilization of excess liquidity through these methods resulted in
checking the slide in the interest rate. It was observed that where lending
rate did not fall in nominal terms at the time of change in the Reserve
Requirements, inflation was also declining. However, in the case of Pakistan
The State Bank could have prudently controlled
liquidity by using inflow of capital to retire expensive foreign debt. But the
State Bank did not formulate a policy in this regard. The Bank should have
planned prepayment much earlier. The Bank did it; but it was too late and too
little. Also, the State Bank allowed the government to borrow an unlimited
amount from banks at a low rate of interest. The Government, in order to keep
low interest rate on its debt instruments, borrowed heavily from the State Bank
to finance its maturing loans from commercial banks which would not rollover
the government debt at low interest rate. Thus as of 25th June 2005,
governments net budgetary borrowing at Rs. 68.78 billion was the result of
government borrowing of Rs. 154.55 billion from the State Bank and retiring
their debt with the scheduled banks to the amount of Rs. 85.77. In the process
of maintaining a low rate of interest, the SBP allowed increase in liquidity on
two counts: gave additional resources to commercial banks and added to reserve
money which is the base of monetary expansion. It is not clear whether this was
a deliberate policy of the State Bank or was manipulated by the Finance
Division. All the same, it is a fact that the State Bank compromised in every
possible way to keep the interest rate at an unsustainably low level.
Therefore, the Government benefited greatly from
the low interest rate environment, as it was able to reduce substantially its
cost of funding from both the bank and non-bank sources. The reduction in cost
of borrowing helped reduce the future debt servicing cost and created a fiscal
space for the initiation of development programs. The government was able to
make pre-payments of expensive external debt amounting to US$ 1.17 billion
during FY04 (the Government should have done more).
The low cost funds available to the corporate
sector enabled many companies to strengthen their balance sheets, improved
profitability and invest retained earnings along with bank borrowing for
expansion, modernization or enhance capacity utilization. Due to availability
of cheaper bank financing, corporate issuance of TFCs had declined in the
preceding two years. Banks moved into new areas of business such as housing,
SMEs, consumer durables and agriculture. Thus, higher demand for funds by the
private sector and increased public sector development spending helped meet the
postulated targets of the domestic economy.
At one time it was feared that the State Bank
could run out of stock of treasury bills. It is difficult to visualize what
would be the reaction of the State Bank under such circumstances. The advisable
course for the State Bank was to absorb excess liquidity through Open Market
Operations (OMOs) and not allow the sharp decline in the interest rate. Also,
the State Bank could have issued its own paper to pick up excess liquidity in
which case the State Bank could be more aggressive and determine the level of
interest rate in accordance with the macroeconomic fundamentals[10].
However, it appears that the State Bank had decided in favor of cheap credit
which could benefit the Government, the banks and the corporate sector.
(XX)
State Bank's Present Stance
The April 11th hike in the discount
rate was a long awaited step in the right direction. For the first time, the
Governor of the central bank had talked about the need to ease the rapid pace
of private sector credit expansion. Although this pace had been excessive for
over two years, it is better late than never to take corrective steps.
Also the impressive sweep of the April 13th
T-bill primary auction in which the State Bank accepted all the bids on offer
and pushed up the rates was sufficient. The end in view was to reduce
inflation. Hence, the immediate focus of the central bank should be to reduce
the pace of credit expansion. The government may not like this to undermine
economic growth. Hopefully SBP will not be deterred by such external
compulsions, and proceed with its duty to enforce monetary control.
The market feedback about the discount rate hike
has been mixed. Some claim this will hit corporate profitability; undermine export
competitiveness; reduce demand for credit (both consumer and corporate);
increase the fiscal deficit; and slow growth. However, others claim that since
inflation is still higher than revised lending rates, this will not have much
of an impact on the economy. Car assemblers and manufacturers of consumer
durables seem to echo the views of bankers that this adjustment may not be able
to make a dent on the pace of credit expansion. Even the Ministry of Finance is
of the view that this increase in interest rates will not impact aggregate
growth (in other words, the credit that has been driving growth is likely to
remain in place).
To formulate an outlook, the following factors
are important:
- In terms of
overall M2 growth, the bumper wheat crop and the enhanced support price
has resulted in a credit expansion of Rs. 21.82 both (
- The bailout
package for the stock market entails funding from banks, has contributed
to credit expansion to the private sector, which, as of
To reduce credit expansion banks will have to
stop discretionary loans. The market-based avenue to do this is to incentivize
banks not to lend. This can either be done by enticing banks into government
securities, or by draining away available liquidity. To entice banks into
securities, returns would have to be jacked up sufficiently, so that on a
risk-reward trade-off, banks would rather lend to the government than to the
private sector. This will require a substantial increase in the rate and supply
of PIBs, so that private sector assets cannot compete. With inflation close to
double digits, the quantum increase in market rates is likely to be very large.
In terms of draining liquidity, either SBP
rethinks its OMOs and ensures that bank liquidity remains tight or cash reserve
requirements (CRR) should be increased. A one percent increase in CRR will
absorb Rs. 22.5 billion, which means CRR would have to be increased by 2 or 3
percent to be meaningful. However, CRR is a very blunt instrument, which harks
back to the days of direct monetary policy. Its use in a non-emergency situation
shows that SBP is unable to use interest rates for monetary control.
A far superior option is to increase liquid asset
requirements. At present, this is 20 percent of demand and time liabilities
(DTL): CRR is 5 percent and T-bill/PIB holdings are 15 percent. The best option
SBP has is to increase liquid assets to 25 percent, with the requirement that
only T-bills should be eligible. Increasing SLR is a signal of monetary
tightening, but is not as brutal and inefficient as increasing CRR.
Increasing SLR, provided
banks are not holding excess securities, would strengthen the balance sheet of
banks by forcing them to hold government securities instead of private sector
assets. There is little doubt that this drying up of private sector credit will
hurt and attract negative press. However, in this euphoria of high growth,
someone has to step on the brakes, otherwise the banking system is heading
towards trouble – the only question is, how systemic the problem is and how
many banks go under.
SBP is unable to bring down inflation in the next
few months. However, it must show real intent – that it is taking tough steps
to reduce the expansion of private credit irrespective of the pain it will
cause. Only this will determine whether the central bank is serious about its
main responsibility – price stability.
(XXI)
Inflationary Pressures
In its monetary policy statement in July 2003 the
State Bank said that inflation should not be the only policy objective in
countries like ours and the Central Bank rather should pursue balanced policy,
ensuring growth promotion coupled with containment of inflation, since
employment generation was possible only through high growth to improve the
welfare of people. Yet in practice the State Bank has clearly compromised its
policy objective of maintaining price stability. The Bank has patronized growth
at the expense of price stability. The
cumulative monetary overhang of 26.5%, as of end June 2005 will manifest itself
sooner or later.
Despite a massive monetary expansion of 19.6%
during FY04 the increase in Consumer Price Index (CPI) remained low at 4.6%.
The fact is that at the macro level, the sharp increase in money supply has not
had an immediate inflationary impact for two reasons: one, there is always a
time lag between the injection of surplus liquidity and its impact on prices;
and two, since this funding was generated by the accumulation of foreign
assets, the inflationary impact was further delayed and was less direct. The
impact is still pending. Although the
recent increase in price is to an extent cost-push factors (e.g. basic food
items, which constitute 40 percent of the basket), the monetary overhang
continues to impact the Consumer Price Index (CPI). The recent increase in CPI
has been driven by food items and the house rent index. Food prices have increased because of the
government’s unsuccessful effort to increase the supply of key items (wheat,
sugar, etc), while the house rent index is computed on a basket of construction
inputs. Government’s unsuccessful
efforts to contain inflation and SBP’s measured tightening of monetary
policy, has not given much comfort to the market. The injection of liquidity in
the past three years has not been a part of an ambitious development agenda,
but resulted from reverse capital flows and excessive borrowing from the
banking sector. This means the liquidity
is largely controlled by the economic elite, which implies purchasing power
still remains with the rich. Over time,
however, this purchasing power will filter down to the working class, which
will eventually begin to impact the prices of basic goods and services (demand
pull).
As stated earlier, three intra year adjustments
in the target rate of increase in prices signal that the State Bank does not
have a proper handle on monetary policy. Inflation during 2004-5 is close to
double digit compared with the original target of 5%. In its assessment of
actual inflation, the State Bank has virtually completely ignored the time lag
between monetary expansion and its impact on prices. Also, the recent
tightening of monetary policy through increase in interest rates shows that:
a)
to be effective in developing countries like Pakistan
b)
for the corporate sector, it is the availability
of credit more than the level of interest rate which is more significant .
Therefore, the State Bank has to rectify its
stance of accommodative monetary policy.
The State Bank admits in its second quarterly
report 2004/05, that a sharp increase in inflation has reduced the
competitiveness of the export sector. However, the State Bank is not clear in
its interpretation of monetary management when it says, “the regime of
relatively cheap credit is contingent on fiscal discipline and pro-growth
policies”.
The State Bank has not come
around to accept that the current inflationary pressures are largely the result
of a loose monetary policy. The State Bank continues to believe that easy
monetary policy is just one of the factors and that cost push factors like
increase in the prices of food and oil are causing inflation. The State Bank
conveniently forgets that the cheap credit policy added to effective demand in
a big way; that the stock of bank credit to private sector jumped from Rs.
800.46 billion at the end of June 2002 to Rs. 1664.56 billion as of 25th June, 2005 ,
an increase of about 108% in three years. Earlier, bank credit to the private
sector had increased by 112.9% in seven years from end June 1995 to end June
2002. Also credit deposit ratio rose from 54.9 as of end December 2002 to 68.9
as of 25th June,
2005 .
The third quarterly report of the State Bank on
the state of Pakistan
“The impact of rise in aggregate demand due to
easy monetary policy would be effectively curtailed through tightening of
monetary policy, however, following fiscal and administrative measures are required
to ease the inflationary pressures emerged due to supply shocks”: the report
further says, “the hoarders should be dealt with according to the regulations.
It has been observed that the abnormal profit margins at retail levels are
prevailing in the case of vegetables and fruits. Formation of effective
consumer associations may monitor these margins and advise the consumers about
the appropriate prices of these items, or to avoid consumption of some item, if
price is unreasonably high. Alternatively, responsibilities of the existing
price control committees may be extended”. The bottom line is all the more
imaginative “Since price setting is all about the price elasticity of demand,
consumer may show resistance though collective actions”.
The report suggests eight fiscal measures to
contain inflationary pressures. With these recommendations, the State Bank is
passing on the buck to the government and the people of the country. However, a
timely action by the State Bank to tighten monetary policy would have obviated
the need for such an advice.
(XXII)
Are There Price Bubbles in the economy?
Theoretically, price bubbles (of assets) are
created where there is (i) price inelastic demand and (ii) ample liquidity.
Price inelastic demand means that supply will not increase in response to
demand and excess demand is met by sufficient liquidity in the system.
Fragmentary evidence suggests that the sharp increase in prices are
concentrated in elite residential areas in three cities and as far as the stock
exchange is concerned the activity appears to be concentrated in a handful of
scrips. Thus, fixed supply and ample liquidity have given rise to increase in
the price of assets.
(XXIII)
Political Considerations
The signal from Islamabad
There is an increasing pressure on market
interest rates, as inflation has picked up quite sharply. There is also an
implicit assumption that increasing T-bill and PIB rates will undermine the
high growth projected for this year. At the very least, the authorities would
want to ensure that the increase in market rates is not so sharp that banks
have less free liquidity and start pricing up loans to the private sector.
Since the government wants to maintain the growth momentum, it will want to
ensure a smooth flow of consumer financing.
Conclusion
What has been happening in Pakistan’s banking
system is the classic case of using an easy monetary policy to jump start
economic growth. There was a sharp
acceleration in private sector credit following the SBP’s decision to stop
supporting market interest rates in November 2002; this followed the equally
sharp fall in lending rates as banks desperately deployed liquidity. To ensure
strong aggregate demand, retail petroleum prices and electricity rates were
kept low. The resulting subsidy bill was
effectively the government’s first line of defense to ensure that inflation
does not rise further.[11] As the subsidies remained in place, the
fiscal cost continued to rise. With recent adjustment in the petroleum prices
the burden has partly been shifted to the consumer with clear implications for
price increase.
The financial system is basically a closed
circuit where funds flow from one agent / institution to another. If surplus
liquidity is injected beyond the nominal growth of the economy, a monetary
overhang is created. Despite the distinction between core and non-core,
inflation is inevitable, even if it has not been fully captured by inflation
indices. Unless the excess liquidity is absorbed, or its future growth is
brought down, inflationary pressures will remain and spread.
To ensure a soft landing, the State Bank should
continue to tighten monetary policy. The balance of payments deficit-including
a record trade deficit of over $6.00 billion during 2004-05 will also absorb
some liquidity. The State Bank should not compromise on holding the price line.
Before 11th April 2005, there was the general impression that there
was no Central Bank in the country and there was no monetary policy. The State
Bank has to improve its image.
Sustainable economic growth requires more than cheap credit. It needs macro
stability; a sustainable source of long-term funding; proper debt management;
and a pool of educated (and healthy) workers who can be trained to compete. The
latter is unlikely to be realized by trickle-down economics, which means a
result oriented focus on social development is needed. The perceptible loss of
price stability and the vulnerability of the banking system are fundamental
issues that need to be addressed if the country is to sustain high economic
growth.
An unbiased assessment shows that in the past three years or so the
SBP’s objectives were as clear as they were misplaced. The central bank was more interested in
growth and justified rising inflation as the cost of higher growth. By prioritizing the government’s growth
objective, SBP had effectively downgraded its responsibility to maintain price
stability. Furthermore, the fact that
the State Bank expressed concern about asset bubbles, without taking
responsibility for the liquidity that created bubbles, is misleading.
The on-going stock market crisis and the decision to get banks involved
in a bailout, is an ominous sign. With
banks already over-exposed in an environment of rising interest rates, to
impose this bailout package will not only spike private sector lending, but
also leave banks vulnerable to the stock market.
Also, recent actions of SBP suggests a blurring
of responsibilities between the government and the central bank. Although these institutions are the most
important policy making institutions in the country (and constitute the
economic team), it is important to remember that there should be a healthy
level of tension between the two since these institutions have conflicting
end-goals. In other words, the
government is primarily focused on growth (even on the back of subsidized
credit or inflationary finance), while the central bank should prioritize price
stability (even if it reduces economic growth).
This is an integral part of the needed check on a government that can
tax, borrow and print currency notes.
When this distinction is no longer meaningful, there is a tendency to
strive for high growth even if it unhinges macro economic stability. Unfortunately, this is what happened in
Pakistan. In other words, the central
bank had internalized the government’s agenda over its own responsibilities. It
appeared that (i) credit plan (ii) price stability as an important objective
and (iii) autonomy of the central bank had lost their relevance.
(XXV)
Future Outlook
1. If SBP
wants to rein in credit expansion, it must continue to tighten liquidity
2. Increase
in SLR may be required besides further increase in discount rate if banks’
discretionary lending to the private sector does not ease off
3. Inflationary
pressures are realized after a time lag, which means no immediate fall is
expected as a direct response to monetary tightening
4. To
contain dollarization, SBP may adopt a more aggressive stance in terms of
increasing domestic interest rates
5. The
increase in interest rates (and possible depreciation of the Rupee) will bring
the economy back to macro equilibrium:
a. M2
growth will ease as private sector credit expansion slows
b. Inflationary
pressures will start subsiding
c. The
current account deficit will start narrowing
d. The
gap between savings and credit will start narrowing, so that banks will not be
running large maturity mismatches.
Credit expansion to the private sector is likely
to be around Rs.400 billion by end June FY05. If it does not ease during
2005-06, the exposure of the banking system will be so large that any shock
(internal or external) could easily undermine the health of the banking system.
The advisable course for the State Bank for the
next few years is to keep the rate of increase in money income (% increase in
GDP plus increase in prices) lower than the rate of monetary expansion by a
margin that should enable it both to absorb a part of the monetary overhang
(now about 28.0%) and allow only a modest increase in prices. This will not be
easy. Yet holding the price line should be regarded as a non-negotiable
objective by the Central Bank.
References
Anjum
Nasim ‘Determinants of Inflation in Pakistan
Dr.
Ishrat Hussain: ‘Leading Issues Facing Pakistan Economy’ Lecture delivered at
the Centre for Development & Democracy, Karachi
Dr.
Ishrat Hussain, ‘Economic Challenges Facing Pakistan’ Lecture delivered at the
Centre for Development & Democracy, Karachi 19th January,
2001 .
M.
Ashraf Janjua, History of the State Bank of Pakistan
M.
Ashraf Janjua, (edited) ‘Monetary and Credit Control in Pakistan Pakistan
M.
Ashraf Janjua, Central Bank and the Government SBP Printing Press, 1989.
Rashid
Amjad (Director, Policy Planning, International Labor Organization (ILO)’ Geneva
Richard
Porter, ‘Monetary Policy in the Economic Development of Pakistan’ in Studies
in Economic Development (with special reference to Pakistan
State
Bank of Pakistan
SBP Annual Report FY03.
Statistical
Bulletin August 2004, SBP.
State
Bank of Pakistan
Sartaj
Aziz, ‘Was the 1990s a ‘lost decade’? Dawn, Feb. 11, 2001 .
S. A.
Meenai, Money and Banking in Pakistan Oxford
University
This article is the revised and updated version of
the paper which the author presented at the First Annual Conference on the
Management of Pakistan Economy organized by Lahore School of Economics, Lahore April 28-30, 2005 . Views in
this article are those of the author and not necessarily of the CBM or Lahore
School of Economics.
**
Financial system comprises (i) Regulatory authorities (ii) Banks and non-bank
financial institutions (iii) financial markets: money, capital and foreign
exchange markets and (iv) Financial infrastructure i.e. legal framework,
accounting, auditing, Human resources and skill and information system etc.
* M2
comprises (i) currency in circulation (ii) demand deposits with scheduled banks
(iii) time deposits with the scheduled banks and (iv) other deposits with the
State Bank. M1 comprises M2 minus time deposits of
scheduled banks. M0, which is reserve money comprises (i) currency
in circulation (ii) currency in the tills of scheduled banks, (iii) scheduled
banks reserves with the State Bank and (iv) other deposits with the State Bank.
[1]
The decision to discontinue the scheme of credit ceilings was made on 14th January, 1992
to be effective from 1st
July, 1992 . The credit- deposit ratio as an instrument of credit
management became effective from 1st
August, 1992 .
[2]
The State Bank had started OMOs on ad hoc basis in October 1991, and upto
September 1995 were conducted on a very restricted basis. SBP sold Treasury
bills from its portfolio in the case of surplus liquidity in the market.
[3] In
the real sense ‘in July, 2000’ because although Pakistan declared free float in
may 1999, it did not observe the basics during 1999-2000 as there was no IMF
program in place and authorities took steps to stabilize the rupee as they
wished. (cf. SBP Annual Report: 2000-2001 pp. 152, 154).
[4]
Dr. Ishrat Hussain, ‘Economic Challenges Facing Pakistan’ Lecture delivered at
the Centre for Development & Democracy, Karachi on 19th January, 2001 .
[5]
Sartaj Aziz, ‘Was the 1990s a ‘lost decade’?’ Dawn, Feb. 11, 2001 .
[6]
Rashid Amjad (Director, Policy Planning, International Labour Organization
(ILO), Geneva ),
‘Solving Pakistan’s Poverty Puzzle: Who Should We Believe? What Should We Do?’,
PIDE, January 2004.
[7] ibid
[8]
Dr. Ishrat Hussain: ‘Economic Challenges Facing Pakistan’ Lecture delivered at
the Centre for Development & Democracy, Karachi on 19th January, 2001 in ‘Leading Issues
Facing Pakistan Economy’ – March 2000-February 2003.
[9] In the
case of Pakistan
the length of lag has been calculated by Prof. Anjum Nasim of LUMS in his
monograph on “Determinants of Inflation in Pakistan ” and by Manzoor Hussain of
State Bank of Pakistan .
[10]
Reportedly the option was not resorted to, one reason being that the rules
governing the operations of the State Bank do not allow this. It appears that
the State Bank is always caught off-guard whenever there is an unanticipated
emergency. Precisely the same thing happened when there were scandals of
Finance Companies in 1979 and again in 1987-88. By the time the State Bank got
the requisite powers and started inspection etc. operators of Finance companies
had made away with peoples’ money. Laws can always be introduced on an
emergency basis if one is clear about the urgency of the objective.
[11]
This effort to contain inflation simply postponed the issue and increased the
magnitude of the problem.
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