Socio-Economic repercussions of further tightening of monetary policy

Mehmood-Ul-Hassan Khan

As expected the central bank of the country SBP announced its recent monetary policy for next six months. It maintained its tight monetary policy. It has raised its policy rate by another 100 bps to 13 percent from 12 percent. It will be effective from July 30, 2008.

Comparative study

It is the fourth consecutive increase in last one year. The discount rate was 9.5 percent at the end of July 2007 and rate of inflation was 7.8 percent. It was raised by 50 basis points on 31st July 2007 (10 percent) on 1st February, 2008 SBP further raised 50 basis points to 10.5 percent while the inflation increased by 1 percent and reached to 8.8 percent and on 23 May, 2008 SBP raised discount rate by 150 basis points (12 percent) and rate of inflation was 17.2 percent

Excess of government’s borrowing

In its latest monetary policy the SBP seriously warned the government about its extended expansion of borrowing from the central bank. The central bank has also instructed federal government to retire Rs.84 billion during the current fiscal year. The SBP’s Central Board of Directors has resolved that the government should retire Rs.21 billion in each quarter of FY09. The government’s borrowing from central bank reached Rs.689 billion in FY08 and the total stock stood at Rs.1.053 trillion. The government borrowed Rs.149.8 billion from May 25 to June 30 and Rs.55 billion during the last two days of fiscal year 2008. High fiscal deficit 4.7 percent, inflation 17-16 percent and high current account deficit forced the SBP to further tightening of monetary policy. The State Bank did not make any change in both Cash Reserve Ratio (CRR) 9 percent and Statutory Liquidity Ratio (SLR) 19 percent as of May 23rd, 2008.

Logic of tight monetary policy

Being the central bank of the country, SBP is trying its level best through its tight monetary policy to curb the high ratios of inflation and decrease widening fiscal deficit since 2005. Widening fiscal deficit is one of the main causes of spreading instability in our macro-economic growth. Between July and December 2007 fiscal deficit was 4.7 percent. Between January and June 2008 it rose to 7.0 percent. Fiscal deficit FY08 is now Rs.865 billion or 8.3 percent of GDP But the real interest rates in Pakistan are still negative or close to zero then how the common people can decide to deposit their monies in the banks.

High ratios of inflation

According to the report, the average headline inflation for the year is 12 percent. Furthermore, in relation to KIBOR at 13.5/14.0 percent there is a nominal difference. But year-on-year inflation at 21.5 percent the real interest rates are negative by a big margin. At 13 percent REPO rate it is at least one percent more than the average headline inflation. The reserve money for last two years is up by over 21 percent but there is a qualitative difference as compared to the previous year. It has bitter reality and tightening of monetary policy for the last three years verifies that monetary policy alone cannot contain inflation in the country. It is commonly feared that if the supply chain is not improved the gap could remain unchanged and the expected favourable impact on inflation will be diluted. According to the report the difference between domestic demand and supply is expected to widen further. “the real aggregate demand had grown by 7.1 percent while the real aggregate supply rose only by 5.8 percent.” Without the price stability the continued tight monetary policy may be ineffective. More diversified but integrated holistic approach should be adopted to curb the high ratios of inflation. It badly needs coordinated fiscal policy responses to further contain demand pressures within the economy capacity and resources.

General estimations

Keeping in view all the negative tends in the economy it would be hard to achieve GDP, GNP, exports and even tax collection targets in the fiscal years. Only effective remedial approach may be further curtailing expenditure on the part of the government failing to which the fiscal deficit target of 5.5 percent is bound to exceed.

Weak global economy and Pakistan

The emerging negative trends in the global economy are also directly and indirectly responsible for our recent macro-economic meltdown. The sub-prime mortgage crisis in US in 2007, the continued international financial markets turmoil, rising global grain drain, high prices of crude oil, skyrocketing food staples prices and a gradual slide in the US dollar against major currencies are spreading a degree of recessionary tendencies and inflationary pressures across developed and developing countries and Pakistan is not any exemption.. High levels of political and economic vulnerabilities have geared-up the lowering of macro-economic growth. So it is predicted that tight monetary policy is here to stay for the longer period of time in the country.

Domestic meltdown of macro-economy

The external current account deficit may be above the target in the current fiscal year. It grew to US $14 billion, equivalent to 8.4 percent of GDP which has left no option for the government to do some thing meaningful to poor people of the country. In FY08, oil and food imports requirements constituted around 40 percent of total import payments. With non-oil non-food imports registering a strong growth momentum (24.2 percent), aggregate growth in imports was 31.2 percent that is much higher than the last five years average of 24 percent. It is also predicted that scenarios of high discount rates will remain high due to further worsening of macro-economic indicators in the fiscal year.

Predictions for the FY09

It is seemed that the trade offs are not easy and global economic environment continues to be burdened with high degree of uncertainties. International liquidity squeeze persists and Pakistan sovereign rating prevents tapping international markets, and international commodity prices remain high.

Pre-emptive policy actions/suggestions

(a) To make it more logical and achievable/controllable, budget deficit for FY09 has been rolled back to 4.7 percent of GDP and government has committed itself to achieve net zero borrowing from SBP during the course of the year, while enhancing its reliance on other non-bank sources.
(b) Government ought to amend the Fiscal Responsibility and Debt Limitation Act, 2005 to include provisions for recognizing the need to phase out the Government’s dependence on SBP borrowings over a period.
(c) Fiscal framework for FY09 should be dynamic to incorporate necessary adjustments as economic developments evolve. Early indications are that the budget deficit target for FY09 of 4.7 percent of GDP is already coming under stress.
(d) The government should provide subsidy on imported oil and government should plan to explore oil and other natural resources like gas, and coal.
(e) Long term investment and consistent policies require stable political government and stable political government and democracy require a just judicial system.
(f) In order to enhance the food production, farm productivity and streamline the supply chain the government should pay attention to agriculture sector by providing subsidy loans, fertilisers, seeds, pesticides and consultancy services to farmers
(g) In order to negate the bad effects of high discount rates more meaningful and effective incentives in terms investment friendly policies like tax holidays, cheap energy and raw material to the industrial sector should be given.
(h) The government should adopt the policy of self-reliance and strictly apply simplicity drive.
(i) Indirect taxes play a prominent role in boosting prices. Direct taxes contribute only 34% while indirect taxes 66% which is too much. Producer shifts the burden of indirect taxes on consumers by increasing the price of taxed items. So it should be rationalized.
(j) Ours is the energy deficit country. Kalabagh Dam project has been abandoned. Due to shortage and high prices of electricity, the cost of production is high, as a result food and non-food items are expensive. Dams should be constructed and government should adopt cheapest sources of energy. Provision of adequate water to agriculture sector would definitely bring the prices down as commonly practiced in India, New Zeeland and Netherlands.
(k) Fiscal deficit, trade deficit and current account deficit are responsible for inflation. The government should take holistic action to remove these deficits.
(l) Smuggling, white-money, parallel economy, undocumented economy, black-marketing, hoarding and profiteering have also been a source of an increase in general prices in the country. It is estimated that annual generation of black money is about 25% of GNP of the country. In the country there is no magistracy system now which was present since before 2000 due to which price stability mechanism has already been collaposed.
(m) Loans to small traders, businessmen, corporate entities and developers will have a positive impact should be treated separately.

General plea of the business community and other side of the picture

Majority of the country’s businessmen termed the monetary policy un-friendly for the business and stressed that central bank should adopt alternate measures to arrest rising inflationary trend in the country. Traders believed their business will be jolted by the enhancement of discount rates from 12 to 13 percent and the monetary policy will fail to counter inflation. It has multiplier effects on the domestic industry too. The import of raw materials will become more expensive for local industrialists which ultimately further increase cost of production. It is feared among the businessmen that the country’s leading export sectors will become weaker in the global markets and it would be difficult to achieve the exports target of $22.1 billion for 2008-09. The monetary policy will also dent country’s exports sector resulting in decline of foreign exchange reserves. Pakistan was on its way to becoming one of the most expensive countries of the world.

SBP clarification

It remained common perception in among the business community that the tightening of the monetary policy had raised the share of financial expenses within total expenses. But according to the audited accounts data of non-financial companies listed at Karachi Stock Exchange showed that in 2007 financial expenses constituted only 2.4 percent of overall expenses, compared to 4.7 percent in 2001 In growth terms, during 2007 total expenses grew by 12.1 percent, of which financial expenses increased by 0.7 percent only. It confirmed that the contribution of financial expenses in overall rising expenses was small. Industry is paying more for oil and other imported raw materials and capital goods in line with rising international prices and utilities and transportation costs, and wage costs have risen due to the rise in minimum wages and tight monetary policy is not the main cause of their worries.

Selling pressure at Karachi share market continued and KSE-100 index lost 130.30 points to close at 10,448.19 points due to increase in discount rates in recent monetary policy.

Concluding remarks

Economic is complicated and technical discipline and it always works in integration. It is necessary to initiate holistic policy to curb high ratios of inflation and not just relying on tight monetary policy. Government’s borrowing needs to be rationalized and should be within the limits. A fund is urgently required to be created to reduce the circular debt among oil and gas producing companies and utilities and IPPs.