As widely anticipated, that State Bank of Pakistan (SBP) has again decided to keep the policy rate unchanged at 14 percent for the next two months.
The SBP has justified its decision mainly on the basis of its confidence in the government's commitment to contain the budget deficit through the implementation of a number of fiscal reforms and by factoring improved external position into the equation. Also, though it was not explicitly stated in the press release on 21st May, 2011, relative "stability" in the inflation rate in the recent months, albeit at a higher level, might have lulled the minds of the Board Members of the SBP not to disturb the status quo.
Commenting generally on the merits of its position, the State Bank has asserted that it was "endeavouring to strike a delicate balance to address the multiplicity of considerations in formulating the monetary policy stance such as containing inflation, promote private productive economic activity, and keeping financial markets stable".
In keeping with the tradition, the State Bank, while announcing the monetary policy decision, has again analysed the latest situation of the economy due to its belief that the monetary policy stance of a central bank and the unfolding economic situation of a country are closely inter-linked. The SBP is of the view that the overall current economic conditions of the country reveal a mixed situation.
A remarkable improvement in the current account, a surplus of dollar 748 million during July-April, 2011, was a major positive development due mainly to spectacular rise in international cotton prices and the rising flow of remittances. This has helped to increase SBP's foreign exchange reserves to dollar 13.7 billion by 18th May, 2011. Nevertheless, caution needs to be exercised while assessing the outlook of the balance of payments position.
This is due to the fact that international prices of cotton have eased, oil prices are likely to continue at around dollar 100 per barrel, debt obligations are due in FY12 and continued suspension of IMF's SBA has implications for financial inflows. As such, the stellar performance of the external sector may be difficult to sustain.
Large budget deficit continues to remain a key challenge for the authorities. Although final outcome will depend upon the realisation of the targets of FBR and provincial revenues, yet because of the adjustment of Rs 120 billion to address the old circular debt issue of the power sector, fiscal deficit for FY11 was likely to increase by 0.7 percent of GDP over the revised deficit target of 5.5 percent.
The rising total debt, Rs 11.2 trillion by end-March, 2011, and its servicing was demanding an increasing portion of fiscal revenues. During 1st July-7th May, FY11, incremental government borrowing from the banking system for budgetary support was Rs 614 billion; a year-on-year growth of 28.3 percent. Borrowings from SBP explain almost 80 percent of the expansion in reserve money while total banking system budgetary borrowings explain 90 percent of the expansion in M2.
A consequence of government's borrowing requirements was that private sector credit was squeezed out in terms of the banks' allocation of system's deposits. Thus, the basic intermediation function of scheduled banks was being constrained as the fiscal deficit and commodity operations of the government were financed by deposits at the cost of declining private sector investment.
Though the CPI inflation of 13 percent in April, 2011 was lower than the peak of 15.7 percent in September 2010, its persistence was a source of concern. The output gap - the difference between aggregate demand and supply - was widening, making it difficult to bring inflation down. Wide-ranging fiscal reforms were needed to restore the economy back towards the requirements of the FRDL Act 2005. And for the economy to grow on a sustainable basis, the debt burden to become manageable and inflation to come down to a single digit, the private productive capacity and investment would have to increase considerably and quickly.
We feel that State Bank's analysis of the economy was quite objective and its case to keep the existing monetary stance unchanged was well founded. Since 26th March, 2011, when the last monetary policy was announced, various economic indicators have shown divergent trends but the overall economic scenario, taken together, has not changed to an extent to warrant a shift in the monetary policy stance.
The only factor which could have necessitated lowering of the discount rate was a substantial improvement in the external sector accounts but, as argued by the State Bank, this positive trend may not be sustainable while developments in other areas were not compelling enough to justify a revision in the existing monetary policy. The main barometer to judge the efficacy of monetary policy was its role in containing the rate of inflation but the price pressures in Pakistan were still persisting at a high rate and not likely to subside anytime soon.
The CPI inflation for FY11 was now projected to remain between 14.00 and 14.50 percent and its future course was hard to predict in the absence of concrete budgetary measures that are on the table but difficult to undertake. Growing fiscal and quasi-fiscal imbalances are, of course, the main source of declining private investment, low growth, widening output gap, persistent high inflation, making the task of monetary policy formulation more complicated.
It is more than evident that until the basic source of destabilisation is not properly addressed, positive outcome in other areas cannot be expected. By following the monetary policy statements and other documents of the State Bank recently, it could be easily discovered that the central bank's frustration with the existing fiscal strategy of the country is growing and rightly so.
In relatively good old days, the State Bank used to advise the government on the merits of maintaining a proper balance between revenues and expenditures in a very soft manner, but now the fiscal authorities are not only routinely censured but directly blamed for most of the ills of the economy.
The press release on the monetary policy decision, released by the SBP on 21st May, 2011, concludes with the observation that the policy rate has been maintained at the existing rate because the government is mindful of fiscal pressures, and has resolved to address this issue. The budget for FY12 was expected to reflect this commitment.
In other words, the SBP could raise the policy rate further if the government fails to confront the fiscal imbalances of the country squarely and adequately. Hopefully, parliamentarians of the country would listen to the message of the State Bank and help the Finance Minister in his efforts to alleviate the problem of the fiscal imbalance in the forthcoming budget.
However, such an objective assessment and messages could only be given when the State Bank enjoys full autonomy in its analysis and decision-making process. At present, the State Bank of Pakistan (Amendment) Act, 1997 is being reviewed to meet a performance criteria of the Stand-By Arrangement with the Fund. The latest position is that the Senate has not approved some of the proposed amendments earlier passed by the Parliament and supported by the IMF.
What will be the final shape of the amended Act is not yet clear but the inclusion or exclusion of certain clauses at the end of the day could make a lot of difference in the status of the Central Board. For instance, if the proposed Monetary Policy Committee (MPC) is established under the law, the Central Board of the State Bank could lose its supremacy over the monetary policy formulation and this will have a lot of repercussions in terms of policy analysis and wielding of authority etc.
Therefore, it is very important to analyse all the pros and cons of the proposed amendments and ensure that the Central Board's authority is fully preserved while taking the necessary input from the outside experts in the field. Coming back to the analysis in the press release, the State Bank seems to be upset about the constraining influence of the fiscal deficit on the basic intermediation function of the scheduled banks.
In our view, such a constraint could partly be removed by obliging or impressing upon the scheduled banks to offer higher interest rates to the depositors by narrowing the spreads. Such a policy thrust would improve the intermediatory function of the banks through the mobilisation of higher level of deposits and may also serve to increase the saving rate in the economy.