Policy constraints

A proactive monetary policy is necessary but not
sufficient to tackle high and persistent inflation

By Hussain H. Zaidi

The State Bank of Pakistan (SBP) has maintained the policy discount rate (interest rate) at 14 percent for February-March 2011. The decision has been taken, according to the new Monetary Policy Statement, in an attempt to strike a balance between risks to inflation and economic growth.

With a view to containing strong inflationary pressures, the SBP has adopted a rather restrictive monetary policy for last couple of years. In November 2008, the policy discount rate was increased by two percentage points to 15 percent. In April and August 2009, the rate was cut by one percentage point each bringing it to 13 percent.

In November 2009, the interest rate was reduced to 12.5 percent. In August 2010, the interest rate was hiked to 13 percent. On September 30, the interest rate was increased to 13.5 percent and, subsequently, to 14 percent on November 30, 2010. Despite changes in the interest rate, strong inflationary pressures have persisted.

The monetary policy in general and interest rate in particular is determined by various factors, including the balance of payment position (BoP), fiscal balance, inflation and the real sector growth. Both the present position and future forecast need to be considered. We begin with the real sector or GDP growth.

A modest economic recovery was made in FY10 as the growth rate increased to 4.1 percent surpassing the 3 percent target and 1.2 percent revised growth rate for the previous fiscal year. Economic growth of 4.5 percent was targeted for the current year. However, the heavy floods, coupled with the persisting energy shortage, upset most of the calculations. According to conservative estimates, floods have washed away more than one percentage point of the potential GDP growth; therefore, the actual growth rate is likely to remain below 3 percent.

Fiscal deficit was to be reduced to 4.9 percent of the GDP during the last financial year. However, that revised target could not be attained as fiscal deficit rose to 6.3 percent of GDP compared with 5.2 percent in FY09. For the current financial year fiscal deficit target of 4 percent of GDP (Rs685bn) was announced initially, which was revised upward to 4.7 percent with the consent of the IMF on account of expenditure on the rehabilitation of the flood-hit people and reconstruction of infrastructure.

The fiscal deficit reached about Rs500 billion (2.8 percent of GDP) by the close of the first half of the current fiscal year (H-1FY11) and it is apprehended that the fiscal deficit may surpass 6 percent of GDP for the full year.

Tax collection by the Federal Board of Revenue during H1FY11 grew by 13 percent to reach Rs661 billion against the target growth of 26 percent to bring the full year tax collection to Rs1.66 trillion. The revenue target is difficult to achieve, especially as tax reforms have been shelved. On the other hand, expenditure will continue to rise because of subsidies and security related expenditure.

The decision not to pass the impact of the rising world oil prices to consumers has caused Rs7 billion loss to the government during the last two months. The SBP is of the view that in case the government continues to subsidise oil prices it may bear Rs25-35 billion in additional cost by the close of the fiscal year.

Not only the fiscal deficit but also the way it is being financed is a cause of concern. In the absence of considerable external assistance, the government is heavily relying on the banking system, particularly SBP credit for deficit financing. Between July 1, 2010 and January 15, 2011, the government borrowed Rs352.2 billion from the banking system, including Rs133 billion from the SBP and Rs222.2 billion from scheduled banks. The central bank borrowing has resulted in monetary expansion of Rs453.9 billion during this period. For the full FY11, monetary expansion of Rs877 billion is projected (15.2 per cent growth).

The external account presents a better picture. During H1-FY11, the current account surplus of $26 million was recorded as exports increased by 19.4 percent to $11.12 billion (compared with $9.31 billion in H1-FY10) and remittances increased by 16.7 percent to $5.29 billion (compared with $4.53 billion in H1-FY10). In addition, $743 million were disbursed from the Coalition Support Fund (CSF). The SBP projects 15 percent export growth for full FY11, while import growth is projected to be 12 percent. Current account deficit is projected to be 1.5 percent of GDP down from 2 percent of GDP in FY10.

Finally, we come to persisting inflation -- the main case for continuing with a restrictive monetary policy. During FY08, average inflation was 12 percent, which rose to 20.8 percent during FY09 and was brought down to 13 percent during FY10. The fall in inflation in FY10 was due partly to price deflation caused by global recession and partly to weaker domestic demand. In the first half of the current fiscal year, average inflation was 14.6 percent and is projected by the central bank to be in the range of 15-16 percent for the full FY11.

The SBP attributes the strong inflationary pressures, notwithstanding a rather restrictive monetary policy, in the main to fiscal deficit and the way it is being financed (bank borrowing). Another cause is the energy crisis driven aggregate demand-supply gap as there is both under-utilisation of the existing production capacity and lack of new investment.

As the Monetary Policy Statement notes, “a proactive monetary policy is necessary but not sufficient to tackle high and persistent inflation.” If inflation is to be contained, monetary policy has to be supported by fiscal policy together with increase in output. Much of the inflation that the economy is facing is either supply-side or induced by deficit financing, which monetary policy alone can be of little use in dealing with.