By Dr. M Tariq Majeed, WEEKLY PULSE MAGAZINE, November 04, 2013
Monetary policy plays a key role in controlling money supply and inflation in an economy. A prudent monetary policy is a fundament prerequisite to achieve macroeconomic stability. However, if used recklessly by the monetary authorities, it can also lead to financial fragility, balance of payment crisis and distortion of economic growth process.
The independence of central bank from fiscal manipulation and political influence is critical to conduct a professional and market based monetary policy. However, in the case of Pakistan the role of State Bank of Pakistan (SBP) remained submissive to finance ministry till 1993. Under the original (SBP) Act, this was the ministry of finance which legally and operationally controlled monetary policy. The ministry of finance mixed up the differences between fiscal and monetary policy and misused the monetary policy for budget financing.
In 1994 and 1997, parliament passed a legislation to amend the SBP Act. The amendment to SBP Act freed the central bank of the manipulation of the fiscal mangers and made it autonomous in formulating and implementing a market-oriented monetary policy on a professional basis. Following the legal reforms, the SBP got administrative autonomy. Now SBP was responsible to conduct monetary policy in coordination with fiscal authorities rather than sub-ordination to fiscal authorities.
Following the legal initiatives, the SBP effectively contributed towards macroeconomic management and it was expected that the SBP will further strengthen its autonomy and contribution. However, it was not the case as SBP authorities have submitted to fiscal authorities to finance budget deficits in recent years and have lost control over money supply and inflation, which is the main function of SBP.
The SBP lost its autonomy by giving excessive freedom to the finance ministry for bank borrowing. The former PPP-government printed colossal money during its term. Currency in circulation in June 2008 was Rs1050 billion while it soared to Rs1794 billion in February 2013. The present government also followed the suit and printed massive money- Rs594 billion in the first 45 days of its tenure. The result is ‘too much money chasing too few goods’.
Over the last five years, excessive government bank borrowing to meet the financing requirements of government has unbalanced the pace of increase in money supply with economic growth. Economic growth of our economy is stagnant around 3% while the increase in money supply is 15%. It means the increase in money supply is five times greater than that of economic growth which has grave consequences for poor and lower middle-income group.
The SBP reduced the nominal policy rate from 14% in July 2011 9% in July 2013. It was done in the milieu in which money supply was increasing rapidly and the economy was in the grip of the overhang of liquidity. The SBP used the alibi that inflation had begun to fall and that a lower policy rate will increase credit for private sector and promote investment.
In reality, this policy failed and above reasoning proved to be wrong. Credit to private sector remained stagnant, private investment and savings fell, foreign exchange depleted fast, exchange rate depreciated, money supply remained excessive and inflation kept increasing.
These are the existing larger borrowers and government who are the only beneficiaries from the reduction in policy rate. The government paid lower interest rate on its borrowing and the rich borrowers got an implicit subsidy. Thus both benefited at the expense of small savers and small investors.
The recent increase in policy rate from 9 percent to 9.5 percent on September 13, 2013 is not helpful because reserve money continue to be created by fiscal operations of the government, rather than bank credit to the private sector. To control the policy rate at the margin is not the main job of SBP, it needs to primarily refocus monetary policy on the regulation of the reserve money base. So that it can fulfill its statutory responsibility of keeping monetary policy and inflation under control.
In order to ensure external debt payments on time, the IMF’s main concern is to depreciate nominal exchange rate and to build foreign exchange reserves. The unbridled money supply and accelerating inflation is not the concern of the IMF. The every move of the IMF program is professionally flawed. The major flaw of the program is that it is based on the existing fiscal setup without the professional fiscal reforms of bringing rich and powerful and the non-taxed sector into tax net.
Needless to say that the approach of the IMF and of the government coincided as both choose expediency over professionalism. The outcome is that revenue growth is below the required rate and government is excessively relying on borrowing despite its commitment of no borrowing at all. In this situation, the government is likely to go on with to depend excessively on external and internal borrowing to bridge the fiscal deficit.
Regrettably, monetary policy is failing in its primary legal and professional duty, meaninglessly tinkling with the policy rate, and printing excessive money to finance government. The SBP needs to follow the original SBP Act, rather than rubber-stamping the government’s decisions on money printing and policy rate announcements. History will judge the monetary authorities by the strength of their decisions not by the length of their tenure. Therefore, the prudent and statutory action point for the SBP is to abandon reckless money printing to finance the government.