Critical appraisal of SBP report

The State Bank of Pakistan's (SBP) report for the first half of the current financial year reiterated its unconditional support for the International Monetary Fund (IMF) programme conditions - a pledge restated in the one-page Monetary Policy Committee statement dated 16 April 2020 with the claim that macro stabilization measures were effective 'including the increase in interest rate...realignment of the exchange rate with fundamentals.'

This claim has been challenged by former SBP governors and independent economists given the subsequent rise in the government's indebtedness - each rupee loss vis-a-vis dollar raises indebtedness by 100 billion rupees while the 13.25 percent discount rate effective from 20 July 2019 till March 2020 stifled economic growth rate, particularly the private sector led large scale manufacturing (LSM) which registered negative 2.8 percent in the first half of the current year against negative 1.7 percent in the previous year.

The SBP report notes that while LSM growth was negative 5.7 percent in the first quarter of this year against negative 0.5 percent in the comparable period of the year before yet in the second quarter the rate was zero percent against negative 2.9 percent in the comparable period of the year before. The zero percent was attained on the back of a whopping 97.1 percent increase in sugar output which, as per the inquiry report, with the forensic report postponed, operates under 'manipulated' imperfect market conditions. Analysts also point to the growth rate of LSM hitting rock bottom in the first quarter of the current year with 5.7 percent negative growth thereby registering zero growth in the next quarter.

The report however acknowledges that "real economic activity was somewhat subdued during H1-FY20 and to an extent this could be traced to the impact of the continuing macroeconomic stabilization measures which had a notable impact on the industrial sector;" and then proceeded to maintain that transition from stabilization to growth, in addition to recommendations made in past SBP reports, identifies "suboptimal state of competition in the domestic economy as an area needing immediate attention of the policymakers" while devoting a special section on competition including an assessment of the current state of competition in the country. This area of activity is not within the Bank's area of responsibility and one would have hoped that SBP focused more on reducing inflation and ensuring liquidity in the economy through a discount rate that is comparable to what is available in the foreign exchange market. The report disclaimed responsibility for poor farm output by referring to poor crop yields and water availability as constraints to farm output.

The onset of Coronavirus has further exacerbated the decline in aggregate demand, an IMF programme objective attained through contractionary fiscal and monetary policies, and additionally there has been an outflow of 'hot' money that was attracted by the high discount rate with the half-yearly report acknowledging that "debt market too faced selling pressure, as foreign investors took out over 1.7 billion dollars from T-bill investments in the month of March 2020 contributing to depreciation pressures in the foreign exchange market." And acknowledges that hot money came into short-term government debt securities with "foreign investment worth 1.6 billion dollars in domestic government securities (mainly T bills) during H1-FY20 increased the share of short term external debt from 1.5 to 3.3 percent," and not in portfolio investment "net inflow portfolio investment were relatively lower at 471 million dollars due to retirement of a US dollar one billion 5-year sukuk issued in November 2014."

Foreign portfolio investment rose from 19 million dollars during the first half of the current year against outflow of 420 million dollars last year which the report maintains "reflects foreign investors' increase confidence over Pakistan's economy;" or as is more credibly argued by detractors of this policy due to the exorbitantly high discount rate.

The report further claims that "introduction of a market-based exchange rate and foreign investors perception about its sustainability helped the country attract external financing during the period...a surge in portfolio investment in local currency government securities as foreign investors increased their focus on Pakistan due to reforms initiated in the exchange market and to encash the available risk adjusted returns in fixed income sureties." These claims too are easily challenged with the emerging consensus being that it was less due to the reforms initiated in the exchange market and more to do with the high discount rate of 13.25 percent at a time when interest rates were near zero levels globally. Today with the SBP's 9 percent discount rate, nearly 9 times the global average has attracted a billion dollars in short term government securities.

The report further notes that "though PKR appreciated in both quarters of FY20, the Nominal Effective Exchange Rate (NEER) depreciated in the second quarter (against appreciation in Q1) as the currencies of other major trading partners appreciated against the dollar. However, the higher RPI (relative price index), due to higher domestic inflation, resulted in Real Effective Exchange Rate appreciation in both quarters of FY20." True but this statement needs to be taken in perspective. First, that while the REER appreciated from 90.97 in June 2019 to 95.79 in November 2019 and 95.718 in December 2019 the rupee remained overvalued and has remained overvalued since December 2018, four months before Dr Reza Baqir was appointed in the first week of May 2019.

The provisional data for February 2020 indicates that the REER was 97.2 or in other words the rupee remains undervalued. And secondly earlier this year SBP stated in writing to Business Recorder and has since placed the following in the NEER/REER indices data that the "REER must not be confused with the concept of currency overvaluation (undervaluation)...for assessment of a country's misalignment a more sophisticated analysis is required accounting for factors such as demographics, external and fiscal sustainability, and macro fundamentals over the medium term?" Repeated queries from former governors of SBP as well as independent economists as to why this new definition/ approach, dating from the appointment of Dr Baqir as the SBP Governor on 6 May 2019, was considered appropriate and if so then why does SBP bother to calculate the REER have met with silence. To simply dismiss concerns over the change by stating that the definition is in line with the IMF calculation does not provide a comfort level with an entity that appears to be bending over backward to maintain its pro-IMF stance.

The primary responsibility of a central bank is to keep a check on inflation. True that the IMF projected a rate of 13 percent on the basis of sluggish aggregate demand due to contractionary monetary and fiscal policies, a rate endorsed by Dr Hafeez Sheikh in the budget documents, yet what is ironic is that inflation has been witnessing an upward trajectory since the two economic team leaders were appointed in late April early May 2019 as headline inflation in May last year was less than 9 percent and has been steadily rising as per the Pakistan Bureau of Statistics: a little over 11 percent mid September 2019, over 12.5 percent in December 2019 and 14.5 percent mid January 2020. It then began to decline sharply - to over 12.2 percent in February and 10.4 percent in March 2020 or subsequent to the onset of the pandemic. It is unclear whether the decline is due to keeping 27 out of the 51 components of the Sensitive Price Index constant (with lockdown in place it is doubtful if PBS is able to verify this) with a price decline in only 8 items and a rise in 16 items.

To add to the travails of the poor and the vulnerable, the PBS notes that in December 2019 headline inflation for rural food was close to 19 percent while for urban food it was close to 17 percent. Urban and rural non-food was a little over 10 percent when the PTI took over power in August 2018 with head line inflation at 5.8 percent in July 2018. The next three months' prices remained sticky at 5 percent and rose to 6.8 percent in October 2018. In April 2019, the rate was 8.8 percent. From thenceforth headline inflation rose to 10.3 percent in July 2019, 12.6 percent in September and 13.07 percent in January 2020. In short, inflation appears to have increased subsequent to the induction of the current economic team and the reason can be attributed to the conditions agreed with the Fund on 12 May 2019 when the staff level agreement was reached.

The central bank linked the discount rate to CPI instead of core inflation (which removes headline inflation components that exhibit large volatility from month to month, week to week, particularly food and energy) and the SBP report claims that "easing of underlying inflationary pressures was not sufficient to arrest climbing head line inflation which was largely food inflation....the policy makers, nonetheless, anticipated only temporary impact of these food supply shocks on the future inflation path and kept the policy rate unchanged...." Such inexplicable logic, linking the discount rate to headline inflation, and then arguing that volatility in food prices was anticipated by the 'policy makers' (read the Monetary Policy Committee) prompting them to leave the discount rate unchanged at a high of 13.25 percent. The report further adds that "interest rates also seemed appropriate to the MPC to bring the inflation rate down to the target range of 5 - 7 percent over the medium term" - yet another inexplicable claim as economic activity continues to be stifled and financing instruments (notably reduced interest rates for specific sectors) on offer by the SBP were "unsuccessful in raising private credit."

To conclude, the SBP policy, data and conclusions (other than those borrowed from the Pakistan Bureau of Statistics with a disturbing history of tweaking data with positive political implications) were rarely challenged in the past but are being challenged today by nearly all stakeholders.