Clash of interests

If the government relies on bank

borrowing, restrictive monetary policy would hardly achieve its objective

By Hussain H Zaidi

The State Bank of Pakistan (SBP) has retained the 12.5 percent policy discount rate (interest rate) in the monetary policy for February-March 2010. The rate was earlier reduced by 0.5 percentage points for the preceding two months. Is the decision to continue the rather high discount rate called for?

In a market economy like Pakistan, the three major instruments available to the central bank to manage the aggregate demand are the open market operations, the discount rate and the reserve ratio requirement (RRR). The open market operations refer to the sale or purchase of government securities. Sale of government securities reduces, whereas purchases increase, money supply in the economy. The discount rate is the interest rate at which banks borrow from the central bank. Increase in the discount rate reduces bank reserves and consequently money supply. Reserve ratio is the minimum percentage of their total reserves that the commercial banks are required to keep with the central bank. A high reserve ratio results in reduced money supply in the economy.

Faced with strong inflationary pressures, the SBP has adopted a rather restrictive monetary policy for quite some time. In July 2008, the discount rate was raised by one percentage point to 13 percent. In November, the discount rate was further increased by two percentage points to 15 per cent. Overall in 2008, the discount rate was pushed up by five percentage points. The Monetary Policy Statement for January-March 2009 retained the 15 per cent discount rate. In April and August 2009 the rate was cut by one percentage point each bringing it to 13.

While evaluating the decision to maintain the high interest rate, it needs to be mentioned that monetary policy is determined by four factors. These are the balance of payment position (BoP), fiscal balance, inflation and the real sector growth. Both the present position and future forecast are taken into account. We begin with the BoP position.

During the first half of the current financial year (H1-FY10), the economy registered a BoP surplus of $1.4 billion (bn) compared with BoP deficit of $4.8 bn for the corresponding period of FY09. The BoP surplus is due to improved performance on both current and capital accounts. The current account deficit during H1-FY10 went down to $2 bn from 7.8 bn in H1-FY09. The substantial reduction of the current account deficit is due to reduced trade deficit of $5.8 bn (compared with $8.2 bn in H1-FY09) and increased remittances of $4.5 bn compared with $3.6 bn in H1-FY09). The capital account balance went up to $3.8 bn, compared with $3.1 bn in H1-FY09, mainly due to the International Monetary Fund (IMF) credit and partly due to increase in foreign portfolio investment despite $1.4 bn fall in foreign direct investment (FDI).

The reduction of trade deficit during H1-FY10, resting on 17.6 percent fall in imports, was partly on account of reduced international commodity prices and partly due to decrease in domestic demand. However, in the wake of global economic recovery international commodity prices, particularly those of petroleum products, are on the increase posting a less optimistic outlook for trade and current account deficits during the second half of the current financial year.

The fiscal deficit target for FY10 is 4.9 percent of GDP or Rs740 bn. However, as the SBP notes in the monetary policy statement, the target is difficult to meet primarily due to increase in expenditure caused by the difficult security situation. During H1-FY10 the fiscal deficit was Rs224 bn, Rs30 bn higher than the Rs194 bn target. The increase in budget deficit calls for a restrictive monetary policy as the government is likely to resort to bank borrowing for deficit financing.

Average inflation dropped to 13.6 percent at the end of December 2009 compared with 20.3 percent a year earlier. The fall in inflation has been due to price deflation caused by recession and weaker domestic demand. However, inflationary pressures are likely to be sticky in the downward direction partly due to surge in international commodity prices and partly due to increase in cost of doing business caused by power shortage, increase in utility charges and the precarious security environment. Hence, the SBP has forecast that the average inflation for full FY10 to be between 11 and 12 percent.

The real GDP growth for FY10 is targeted at 3 percent, 1 percentage point higher than that of 2 percent during FY09. Improved performance of the agricultural and large scale manufacturing (LSM) sectors and greater demand for exports in the wake of global economic recovery may help achieve the modest growth target. However, the persistent supply side constraints and the law and order situation may serve as a drag on economic growth.

As the preceding paragraphs show, though major macro-economic indicators bearing upon monetary policy have improved, the economy continues to be susceptible to shocks and uncertainties forcing the SBP to retain the rather high interest rate.

Would the monetary contraction be sufficient to contain inflation? To answer this question, one needs to look at the causes of inflation in the economy. Much of the inflation that the economy is facing is supply-side, which monetary policy can be of little use in dealing with. Take, for instance, high food particularly sugar prices. The major cause of food inflation is cartelization. The cartels create artificial shortages to increase prices. Such supply-side inflation needs strong government action to curb cartels and check smuggling and, when necessary, exports as well. Hence, monetary policy by itself will not be sufficient to significantly reduce inflationary pressures. Strong administrative measures are also needed.

Coming to the likely effects of the current monetary policy, a few observations can be made. One, the high discount rate will continue to put upward pressure on the market interest rates. Though nominal interest rates may be high, courtesy high inflation real interest rates are still low. Two, high interest rates would reduce consumption and investment demand, resulting into fall in output and employment. This is the main argument against the current restrictive monetary policy. When an economy slows down, jobs are lost and incomes fall. This is not to state that the monetary policy is the major cause of economic slump; however, it remains an important factor.

Three, high interest rates should encourage savings. However, one must be mindful of the fact that income not the interest rate is the major determinant of savings. People with high income are willing to save even at low interest rate. Fall in inflation increases the real incomes but fall in employment has the opposite effect. Finally, as interest rate increases, the money holdings will decline and funds will be shifted to higher yield assets. This may result in a fall in the real sector investment and increase in portfolio investment.

The monetary policy is a trade off between growth and stability. The decision to persist with a restrictive monetary policy means that the government prefers stability to growth. The agreement with the International Monetary Fund (IMF) also provides for tight fiscal and monetary policies. However, a tight monetary policy can bear fruit only if it has a supportive fiscal policy. If the government continues to rely on bank borrowing as the major source of financing its fiscal deficit, restrictive monetary policy would hardly achieve its objective of containing inflation.