The money profile is getting more and more skewed towards reserve money and that is implying diminishing money multiplier. The consequence is that the SBP is using excessive reverse open market operations to generate liquidity but that is not serving the purpose to the liking of the central bank. And doves at the helm of State Bank are plausibly deploying the wrong tool to heal the wound of low private credit growth.
In the first half of this fiscal year, reserve money swelled by 12.1 percent, while it was 7.7 percent in the corresponding period last year. And to add to the ado, the broad money grew by seven percent in IHFY13. Although, the growth in M2 is higher as well; the reserve money movement is alarming and warrants some serious attention from the policymakers busy in lowering interest rates without delving into the intricacies of monetary aggregates.
The core of the problem is no stopping to the money going out of the system i.e. building the stock of currency in circulation. The CIC flows stood at Rs219 billion (41 percent of M2) in first half this fiscal versus Rs110 billion (28 percent of M2) in the corresponding period last year. One plausible reason is that its an election year and usually the spending for election campaign is largely in the informal sector.
History endorses this doctrine as FY08 was an election year and reserve money growth was highest in five years. But the trend never reversed in this regime (FY09-todate). There are hosts of reasons for this phenomenon ranging from transfer of income from urban to rural segment owing to higher commodity prices in past few years. Then the government spending and lending dominated the banking system and there is more leakage and corruption in government spending to the private sector.
Getting this money back to the system is half the job done. CIC comprises one third of M1 and the stock is approaching Rs2 trillion. This ratio is twice as much as in India and manifold to what it is in the developed world. By bringing half of this money back to system with a modest velocity of 2.5 times would mean to enhance the deposit base by over 40 percent from existing level of Rs5.9 trillion.
This additional Rs2.5 trillion can provide adequate liquidity after filling the appetite of government to reap fruits for the private sector and excess credit supply would substantially slash the lending rates. But that is a day dream far from the existing political economic realm.
The remaining of this fiscal year elections spending are going to peak and so will the government borrowing, money supply and CIC. And slashing interest rates further is a recipe of disaster as the fear of second round of inflation is looming in the air.