Submitted by: Ali Amjad (7213) & Faizan Sohail

(7133)
2/5/2010
MONETARY THEORY AND POLICY
SECTION “ A “

Report on:

Monetary
policy of
Pakistan
Submitted to: Mirza Aqeel Baig
 CURRENT MONETARY POLICY
STATEMENT IN PAKISTAN
Building on initial gains in macroeconomic stability the economy is looking to
further its traction for sustainable recovery. Inflationary pressures have
dampened but continue to persist, mainly due to alignment of energy sector
prices with market factors. Large Scale Manufacturing (LSM) has consistently
grown since October 2009 after contraction for almost 20 months but
remains fragile. Reduction in the external current account deficit has allowed
SBP to rebuild foreign exchange reserves, despite shortfalls in external
financial flows. However, uncertainty has increased in some areas,
particularly the fiscal sector, with implications for the rest of the economy,
including monetary policy.

Although CPI inflation (YoY) has come down to 13.0 percent in February
2010, it is high and exhibits persistence. After a low of 8.9 percent in October
2009, inflation slipped back largely due to increases in electricity tariffs,
adjustments in the prices of domestic petroleum products, and administered
prices of commodities like wheat. To which extent these factors will influence
other prices in the economy and expectations of inflation in the coming
months remain difficult to assess. Nonetheless, SBP expects the average CPI
inflation for FY10 to remain close to 12 percent.

Despite presence of high inflation, crippling electricity shortages, and

challenging security conditions, domestic economic activity has picked up in
recent months. A cumulative growth of 2.4 percent during the first seven
months of FY10 in the Large Scale Manufacturing (LSM) is encouraging.
Sustainability of this trend in LSM and overall economic growth would
depend on improvements in the availability of electricity and security
situation. In addition, this would need supportive growth in private sector
credit, which in turn depends on a reduction in the scale of government and
public sector’s reliance on bank borrowings.

The balance of payments position has improved considerably. The external

current account deficit has come down to $2.6 billion during July – February,
FY10 compared to $8 billion in the same period last year. This has allowed
SBP to accumulate foreign exchange reserves, $11.1 billion as on 26th March
2010, and has facilitated stability in the foreign exchange market. However,
other developments in the external sector, such as Foreign Direct
Investments (FDI) and workers’ remittances, need to be monitored closely,
especially when prospects of foreign official flows remain unclear.

The key source of uncertainty, however, lies in the weak fiscal position.
Burdened by significant security related expenditures and shortfalls in
revenues, keeping the fiscal deficit for FY10 within target would be
challenging. Partial phasing out of subsidies and reduction in development
expenditures have helped in containing expenditures but has lead to surge in
domestic prices and is hurting crucial public sector investment. Similarly,
increased Petroleum Development Levy (PDL) receipts, due to higher oil
imports, have cushioned the lower tax revenues to some extent but have
contributed towards inertia in domestic inflation. During the remaining
months of FY10, uncertainty regarding non-tax revenues on account of
foreign reimbursements and extent of remaining power sector subsidies
adds to fiscal complications.

The financing mix of the fiscal deficit also seems uncertain. The external
financing for budget, especially the part pledged by the Friends of
Democratic Pakistan (FoDP), has mostly been elusive. Of the Rs110 billion
net external budget financing received during H1-FY10, Rs93 billion were
provided by the IMF. With an understanding that this part of IMF money,
provided in lieu of FoDP flows, is for short term, the importance of the timing
of external budgetary flows cannot be overemphasized. Not surprisingly,
therefore, government borrowing from the SBP has been substantial in Q3-
FY10. According to provisional figures the outstanding stock of government
borrowing from SBP (on cash basis), as on 25th March 2010, stands at
Rs1240 billion, which is Rs110 billion higher than the quarterly ceiling limit.

With less than expected retirement of credit availed by the government for
commodity operations and commencement of the 2010 wheat procurement
season, pressure will build on the banking system resources. Continued
borrowings by the Public Sector Enterprises (PSEs), partly because of the
lingering energy sector circular debt, are also straining systemic liquidity.
Further, the high infection ratio of credit to Small and Medium Enterprises
(SMEs) at 22 percent and Agriculture at 17 percent may lead banks to show
reluctance to extend credit to the private sector even when the pace of
growth of incremental Non-performing Loans (NPLs) has slowed considerably
in the last quarter of 2009.

In this environment, with resources tied up in both commodity and circular

debt and risk averse behavior, banks will tend to negotiate higher rates on
risk-free or government guaranteed debt. For instance, the first issuance of
the Term Finance Certificate (TFC) in March 2009 was priced at KIBOR plus
1.75 percent, while the second issuance in September 2009 was at KIBOR
plus 2 percent. Similarly, the rates for financing commodity operations were
around KIBOR plus 2.5 to 2.75 percent. This reflects that banks are building
in the cost of ongoing rollover, instead of repayment, of outstanding credit.
Thus, the attractively priced government borrowing may lead to stagnation
in private sector credit growth.
Government will have to revisit its commodity intervention strategy, sooner
than later, so that commodity operation requirements may go back to
normal levels. Similarly, a complete resolution of the circular debt would be
essential. Apart from releasing banking system resources and easing
pressure on market rates, it will alleviate some constraints impeding
production of electricity in the country thus paving way for sustainable
economic recovery.

Given the uncertainties pertaining to the fiscal and quasi-fiscal sectors,

present stance of monetary policy is striking a difficult balance between
reducing inflation, ensuring financial stability, and supporting economic
recovery. An upward adjustment in SBP’s policy rate, at this juncture, runs
the risk of impeding the still nascent recovery, while a downward adjustment
runs the risk of fuelling an already high inflation. Hence, SBP has decided to
keep the policy rate unchanged at 12.5 percent.

DOES THE MONETARY POLICY

FAULTERING IN PAKISTAN?
The central bank has kept the discount rate unchanged for the next two
months while downside risks to economic growth have increased. It would
appear that the current monetary policy is merely designed to manage the
balance of payments with soaring debts while depreciating value of rupee
against the dollar is curbing imports.

With high interest rates, falling rupee and credit squeeze, the State Bank has
done very little to stimulate domestic savings, investment, production and
exports. And the inflation rate on which the monetary policy is anchored, is
once again on the rise.
The tight monetary policy is depressing domestic demand and retarding the
economic growth rate. The banks offer negative returns on the average
deposit rates, discouraging savings. The powerful banking lobby opposes
moves by government to step up mobilization of domestic savings (through
National Savings Scheme) that is non-inflationary. High interest rates in low
growth environment are creating bad debts in the private sector and raising
cost of government borrowings, squeezing fiscal space for development of
physical and social infrastructure
The monetary policy is stifling capital formation both in the public and the
private sectors. And despite slow growth, inflationary pressures are again
building up in the economy, with steep depreciation of the rupee pushing up
prices of imported industrial inputs..
The commercial banks continue to profit from exorbitant banking spread.
They prefer to do trading in T/bills –– a risk-free investment — rather than
finance investment in the commodity producing sector. Banks are patronized
at the cost of the real economy, turning the whole financial system
inefficient. The monetary policy is left to grapple with one banking risk after
another because the financial model is facing an organic failure.
Despite the tight monetary policy, the rupee is continuously sliding because
exports are not picking up and now there are indications that growing
workers remittances have touched their peak. In this area too, the growth
trend may be reversed.
The improvement in the balance of payment position is debt-driven and has
not come about as a result of improvement in export earnings which is
expected to drop by another one per cent this year. . And the foreign
exchange reserves are rising on the back of mounting debt inflows. What is
not realized by policymakers is that foreign loans are a short-term vehicle to
manage balance of payments and that foreign money can be no substitute
for domestic savings. Unlike foreign inflows, domestic savings help contain
inflation. Countries with robust savings and investment rates have high
growth with low inflation.
Neither a tight monetary policy nor a sluggish economic growth would help
bring any significant amount of direct foreign investment that has sharply
declined also because of domestic security environment and drying up of
liquidity in the global market The rupee must be stabilized and interest rates
must be lowered to attract investment and boost exports. By allowing 100
per cent payment against the letter of credit on imported goods, the central
bank leaves an impression that the rupee’s slide would not be halted.
As long as the country remains in the IMF programme, (only countries in
distress seek IMF support), foreign investors cannot be tempted to look at
the Pakistani market, unless very lucrative business offers are made to them,
e.g. rental power. This has been demonstrated during Musharraf’s regime
when policy makers moaned that no foreign investment was coming though
the country was under IMF’s programme. It was 9/11 that brought about the
bubble growth.
Finally, policymakers’ efforts to seek foreign assistance have not been easily
forthcoming, whether it is from the United States or the Friends of
Democratic Pakistan (FoDP) group. The only exception is the multilateral
inflows coming from the IMF, World Bank and the Asian Development Bank
with all their attendant conditionality.
The developed world suffers from huge budget deficits, likely to persist for
the next five to seven years. The massive fiscal deficit, created by a bailout
of the banking system, threatens a double dip recession in the United States.
More important, the current fragile economic recovery in the industrialised
world is a jobless one.
The government’s own track record on utilisation of foreign assistance is also
a problem both for the nation and the donors because, in the past, military
rulers patronised the renter class. How much interest the US has in the
region after its possible exit from Afghanistan is an open question. The FoDP
has so far disbursed a mere $400 million from the pledges of $5.2 billion
made by the group in Tokyo. Hopes were first raised in press reports that
much of it would be in the shape of grants followed by revelations that the
pledges would go to finance development projects. Now in the Dubai
meeting, it was stated, that the money would fund public-private partnership
in mutually agreed projects This would take its own time and would not so
easy to materialise. It seems that the FoDP has not moved beyond evolving
concepts that would govern the strategic partnership of the group with
Pakistan.
Taking a long-term view of things, bilateral assistance cannot be relied upon
on a sustained basis. Over the years, it would become insignificant. Foreign
direct investment benefits from a fast growing economy and a sluggish
growth would not attract foreign investors.
Over the past one year ending November, the average deposit rate of banks
has declined by 0.25 per cent. The inflow of foreign money obviates the need
for banks to raise domestic deposits and for the government to raise tax
revenue. Foreign money helps to exempt “sacred cows” from taxation. It
suits the lenders to keep the recipient under debt..
The rising risks to economic growth have not persuaded the central bank to
cut discount rate on January 30. Agricultural output may be much lower than
this year’s target because of scanty rains and low level of water in dams. The
large manufacturing sector grew by a mere 0. 7% in November. Exports are
expected to decline by one per cent this year.
The performance of the commodity producing sectors remains lack lustre.
Fiscal constraints have forced the government to go for steep cut in
development spending, the axe falling on social and physical infrastructure
that is needed to make the economy efficient and globally competitive.
Countries which have focused on the real sector of the economy have
achieved faster and relatively more sustained economic growth. In Pakistan,
unemployment is a more important issue than inflation that can only be
tackled by stepping up domestic savings, investment and production. The
monetary policy is discouraging capital formation in the commodity
producing sectors by making credit expensive and .imported inputs costlier.
No doubt high inflation rate is eroding the purchasing power of the
consumers barring rural areas where better wheat, cotton and sugarcane
prices are providing some relief to consumers in the countrywide. But in a
country with rampant poverty, lower real income is better than no income at
all. The economies that are not focused on production are destined to falter.
A glaring contrast can be found between America, anchored on the global
financial system, and China— the world factory.