The Monetary Policy Statement (MPS) dated 27 July decided to keep the discount rate unchanged at 7 percent with a warning that 'if signs emerge of demand led pressures on inflation or of vulnerabilities in current account it would be prudent for monetary policy to begin to normalize through a gradual reduction in the degree of accommodation."

This was an appropriate decision given the need to continue an accommodative monetary policy with the ongoing fourth Covid-19 wave - accommodative defined as a discount rate lower than the Consumer Price Index (headline) of 9.7 percent year on year in June 2021 (to which the discount rate was linked with disastrous consequences between May 2019 to March 2020) and core inflation (all previous Governors of the State Bank preferring to set the discount rate at a couple of percentage points higher than the core inflation) was 6.7 percent.

MPS is outlined on a regular basis, every two months at present, by the Monetary Policy Committee (MPC) headed by the Governor State Bank of Pakistan and based on key macroeconomic indicators.

However, two elements of the 27 July MPS are disturbing because they are not satisfactorily dealt with. First, the reference to market based flexible exchange rate and the claim that "largely in line with the emerging market currencies, the PKR has depreciated by around 4 percent since the last MPC meeting (28 May 2021) partly as expectations of normalization of monetary policy in the US have been brought forward." Heady words not meant for the uninitiated, and therefore, requiring some clarifications.

First, Morgan Stanley Capital International (MSCI), the world's largest index provider, has proposed reclassifying Pakistan index from emerging market (EM) to frontier market (FM) as Pakistan's equity market has not met the necessary requirements with consultations scheduled for 7 September (the same month as the scheduled deferred sixth review meetings with the International Monetary Fund). The general consensus is that there is a high probability for Pakistan market to be downgraded to FM index. The reason: Pakistan MSCI EM index is only 0.02 percent versus 0.14 percent at the time of upgrade, less than the acceptable tracking error for most active EM funds.

Second, as per The Economist Intelligence Unit on 10 March 2021 "...receding risk aversion in global financial markets, rising prices for many commodities and continued monetary policy accommodation in advanced economies will support many emerging-market currencies in 2021 as investors search for higher yields" - which may well explain the inflows under the Roshan Digital Accounts. However, it is further noted that "against a backdrop of recovering global demand and ample liquidity, many emerging-market currencies that depreciated significantly in 2020 will appreciate this year. However, currency markets will remain sensitive to local economic conditions, and demand will favour countries with comparatively rapid vaccination rollouts." Currencies of two EMs - Brazil and India - have eroded based on the severity of the pandemic due to understating its impact. Pakistan as a case in point has tackled Covid-19 quite effectively in terms of loss of life and its fallout on the economy (which has benefited from diversion of exports orders from India). So the loss of rupee vis-a-vis the dollar should have been laid at the doorstep of local economic conditions.

What is baffling is that the rupee continues to slide though local economic conditions, unexpectedly, were better than projected with growth at 3.94 percent, almost double what was projected; and as per the MPS a contained current account deficit (1.8 billion dollars), all time high exports (an incorrect statement as exports were 25 billion dollars in 2021 while in 2013 exports were 25.1 billion), all time high remittances (in excess of 29 billion dollars), recovery driven by large scale manufacturing sector and construction for which it gave credit to both Ministry of Finance and itself - the former for pro-industry measures in the budget and to itself for accommodative monetary policy and disbursements under TERF facility.

And finally, the MPS notes normalization of monetary policy in the US which the Federal Reserve Board defines in a 2014 document titled "policy normalization principles and plans" as comprising of three elements: (i) increase in short term market interest rates, however, the Fed noted mid-June 2021 target range for the federal funds rate near zero though it did raise expectations for inflation this year and brought forward the timeframe when it will raise interest rates though how these projections would erode the Pakistani rupee is unclear; (ii) reducing size of balance sheet. With the federal funds rate near zero, the Fed has continued to undertake asset purchases, increasing its holdings of Treasury securities by 80 billion dollars per month and its holdings of agency mortgage-backed securities by 40 billion dollars per month - purchases that would help foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses. The Economic Update for July 2021 uploaded on the Pakistan Ministry of Finance website notes that the recently published minutes of the US Federal Open Market Committee revealed that the FED has not yet any schemer to start tapering bond purchases. In any case the impact on Pakistani rupee is minimal if at all; and (iii) transforming assets holdings that involves a reduction in the average maturity of assets and a transition to a portfolio consisting primarily of treasury securities. Again its impact on the rupee is tenuous at best.

The State Bank's major responsibility is to contain inflation however the 27 July MPS reiterates its earlier claims that "the recent decline in inflation is consistent with the MPC's view that recent price pressures are largely supply-driven and transient. Headline inflation should begin to dissipate more visibly in the second half of the year when the February electricity tariff increase drops out of the base, converging to the 5-7 percent target range over the medium-term. Conversely, risks that could raise

inflation include higher-than-expected global commodity prices, especially if these are coupled with upward adjustments in the PDL or domestic energy tariffs, as well as fiscal slippages that lead to stronger demand-side pressures through the year." This statement raises three major concerns as not mentioned: (i) the rupee erosion impacting on higher input/raw material/fuel prices with respect; (ii) heavy reliance on debt to shore up foreign exchange reserves (though it is noted that around 20 billion dollars of external financing needs are expected to be more than fully met not through exports and remittances) the desired form of foreign exchange inflows but through healthy commercial (at a very high interest rate with a small amortization period that is jacking up the budget deficit - a highly inflationary policy), official (dependent on the sixth IMF review being conclusive), portfolio (inflows including Roshan Digital Account due to the yields on offer being more than double those on offer by other countries), and Foreign Direct Investment inflows (with China by far the largest contributor though it requires sovereign guarantees which accounts for the government upping the previous limit of sovereign guarantees from 2 percent of GDP to 10 percent); and (iii) the reference to electricity tariff has stumped all power sector experts and requires a clarification.

The MPS noted that "if balance of payments pressures were to emerge, some normalization of monetary policy may also be needed, especially if demand side pressures are at play." These include (i) the stock of quasi money (the energy sector circular debt of 2.5 trillion rupees today); and (ii) fiscal deficit with the decision to adjust petroleum levy noted as a possible contributor to inflation - which has been unsustainable for the past three years requiring heavy domestic and external borrowing - the inordinate focus of the MPS.

To conclude, the MPS must desist from passing on the buck to the Ministry of Finance or on large scale collusion (referred to as the mafia by the Prime Minister). The issue is also not one of having an accommodative policy and/or currency erosion that may or may not be at variance with other EMs with low vaccination rates; but one of careful calibration before taking decisions which recognize that less than half a percent fall or rise in the discount rate can impact on major macroeconomic indicators as can a less than half a percent rise or fall in the currency value - an exercise which requires expertise in building econometric models.

Copyright Business Recorder, 2021

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