An excellent analysis of current imbalances in the economy
By Aftab Ahmad Khan
As a part of monetary policy statement for July-December 2008, the Governor State Bank of Pakistan, Dr. Shamshad Akhtar has given an excellent analysis of current imbalances in the economy, namely twin deficits (fiscal and current balance of payment deficits) and inflation in the country. She has explained the circumstances and developments both on domestic and international front that led to the unsustainable imbalances. As far as monetary policy is concerned, she has rightly pointed to fiscal developments diluting the effectiveness of monetary policy to contain inflation. All these developments are well known but the governor has succinctly put them in focus in order to indicate what direction should the monetary policy take in the next few months.
Also, the governor has rightly stated that effectively addressing these problems would require the joint efforts of various policy-making agencies, particularly the government. In fact, she has stated unequivocally that cooperation from fiscal authorities is necessary for the intended success of monetary policy. More specifically, the governor, after analysing the causes of excessive demand in the economy – like consumption increasing currently at 8.5 per cent while GDP growth is lower than this figure, leading to decline in domestic savings, has emphasised the need to contain this demand which should make a dent on the twin deficits which at present are unsustainably large.
In concrete terms, the governor has increased the discount rate by 1.0 per cent (100 basis points) to 13 per cent, clearly stating that this would be effective in containing demand for credit. This is possible, provided the government lives up to their policy commitment of retiring Rs84 billion of borrowing from the State Bank during the year i.e. Rs21 billion every quarter. While stating this she said that during the first 25 days of current month (July) the government had already borrowed Rs32.9 billion – which means they would need to retire at least of Rs53.9 billion by 30th September. This looks highly unlikely. For as stated by the governor, a targeted increase of 24 per cent in tax revenue during 2008-09 is extremely difficult to achieve which during the past few years on the average has been 12.8 per cent. It needs to be mentioned that one per cent increase in fiscal deficit over the targeted figure of 4.7 per cent of GDP would necessitate mobilising an additional amount of Rs100 billion.
Without being explicit or specific, the governor apprehends that the government may not be able to retire the promised amount of State Bank debt thus putting the ball in the government’s court as far as the effectiveness of monetary policy is concerned. A careful analysis of the totality of situation indicates that it is highly unlikely that the State Bank will succeed in containing inflation to the targeted level of 12 per cent during 2008-09.
To be more specific, there are several limitations on the effectiveness of monetary policy. First of all about 50 per cent of inflation is due to increase in the prices of oil, food items and industrial raw materials demand for which has increased significantly more than inelastic supply. Also in less than one year, Pakistani rupee has depreciated by 11.5 per cent in terms of US dollar which itself has been under pressure for a variety of reasons. Thus, the prices of imports of all categories have gone up. These increases in prices due essentially to cost-push factors are beyond the control of the State Bank i.e. increase in interest rate or for that matter any other measures to regulate volume of money would not help control this segment of inflation. Added to this is the second round inflation i.e. demand for increase in wages and increase in transport fares and house rent etc. Furthermore, due to higher prices of oil, food and essential imports have also gone up heavily. These second round effects may be to some extent controlled by ‘demand management policy’ but only marginally.
Apart from the fact that increase in discount rate has no impact on cost-push segment of inflation, effectiveness of increase in interest rate for demand management is also limited. The increase in cost of production stemming from one per cent increase in borrowing rate will be very small: may be a maximum of 0.25 per cent of total cost, which will be much less than increase in the prices of products, which are expected to increase by a minimum of 12 per cent during FY-2008-09. If there is a time difference of one month between the purchase of imports and output, increase in cost will be more than recovered because of inflation. Also, a firm that is determined to retain or increase the share of its market will easily absorb this increase in cost of production in its profits.
To conclude, the corporate sector is more worried about availability of credit than marginal increase in cost of production. In addition, given the high rate of inflation in the country, the real interest rate is negative. Theoretically, increase in interest should encourage savings and depress consumption and prices of assets – including property and demand for credit in private sector should be contained. However, given the level of inflation and government’s preference for borrowing from SBP as an easy recourse to finance budget deficit for the above-mentioned ramification are somewhat mild.
Then what should be SBP’s next step to ensure effectiveness of monetary policy? The governor and the members of board of directors of SBP have emphasised the need for the fiscal authorities to contain the fiscal deficit at 4.7 per cent of GDP and have emphases retirement SBP debt in the amount of Rs84 billion. Our point of view is that a dent on inflation can be made even if the government cannot retire this amount but do not borrow any amount from the banking system and finance, the targeted deficit from non-bank sources.
There are clear indications that the size of budget deficit at 4.7 per cent of GDP will be difficult to achieve because of optimistic revenue estimates. For all intent and purposes, the Fiscal Accountability and Debt Limitation Act 2005 has been totally ignored. The government is not serious about resource mobilisation. The outgoing Chairman, FBR stated that an additional amount of Rs500-600 billion is needed to be mobilised to put budget in a good reasonable shape. This is virtually impossible for the government to achieve. Given this situation, one option for the State Bank is to have the Fiscal Responsibility and Debt Limitation Act 2005 amended to include a specified limit on government borrowing i.e. a certain percentage of total deficit or a certain percentage of GDP. Many countries have such provision. If such arrangements are put in place, any violation would need to be referred to the National Assembly/Parliament. Any borrowing from SBP or Banks should be approved by the Parliament, otherwise the State Bank may be authorised to stop lending to the government. Not only the government would become careful in its fiscal affairs but the State Bank will be on firm ground in highlighting its responsibility in the country for controlling inflation. Also, the government has been optimistic about containing import demand. Neither any concrete fiscal nor trade measures have been put in place for limiting it.
Source: The News, 4/8/2008