HISTORICAL PERSPECTIVES OF MONETARY POLICY RESPONSES TO ECONOMIC PERFORMANCE

HAMADULLAH ABRO
RESEARCH ANALYST
Feb 25 - Mar 02, 2008

The interest rate structure is one of the most important indicators of the financial sector, an important determinant of credit flow to the private sector and overall investment activities in an economy. It a major tool used by central bank to manage money by creating ability of banking system to channalize the flow of funds to priority sectors to achieve its broad macro economic goals resulting in overall favorable economic performance.

State Bank of Pakistan has been trying to use effectively the interest rate tool in response to drastically changing economic environment of Pakistan. Her monetary policy stances have witnessed different phases from easy to tight ones over the last 5 years, resulting in Economic growth at an average 7%. SBP has maintained a favorable business environment here in Pakistan translating in growth of major three sectors which include agriculture, manufacturing and services.

During FY06-07 Agriculture grew at 5% (contributed 21% to GDP), Manufacturing grew at 8.8% (contributed 23% to GDP) and services grew at 8% with highest share in GDP of almost 60%. Investment also showed impressive growth of 21.31% (contributing 23% of GDP).

While on the other hand inflation increased to alarming level, fiscal and current account deficit went out of control; other external threats like food inflation along with increasing international Oil Prices. Catering to these issues, SBP has maintained tight monetary policy for the last two to three years.

HISTORICAL PERSPECTIVES

Until recently the economy seemed stable and the monetary and fiscal policies went hand in hand with certain administrative tools to boost demand and confidence of private sector investment, resulting in colossal economic growth.

After nuclear test (1998), several crippling sanctions had been imposed on Pakistan. This lurched the economy from one crisis to another. But soon after 9/11 (2001), huge part of country's debt was written off and/or rescheduled, and the supporting aid created immense fiscal space for domestic development.

In the following year 2002, SBP pursued easy monetary policy by reducing benchmark discount rate to 7.5% from 14% since July 2001 complemented by low cut-off yields on T-Bills and PIBs. As a result, Pakistan's economy performed well. Tremendous improvement was seen in Pakistan, investments amplified, increased remittances flew-in, low Government borrowing, reverse trend in equity markets because of low interest rates, stable exchange rate, inflation down trend, improved foreign exchange reserves, reversal of capital flight (FDI), interest rates to historic lows which gave rise to strong surge in aggregate demand consequently Pakistan's economy moved on growth trajectory during FY04 and grew at 8.4%. Major contributors in growth were Large Scale Manufacturing (LSM), and Retail Trade, which surpassed agricultural sector growth. This was result of domestic aggregate demand facilitated by easy monetary policy, accommodative exchange rate, deepening of consumer credit, credit to agricultural sector, access of small borrowers to banking sector and very low export financing rates. All these resulted in inflationary pressures which rose to 9.3% by June 2005 from 4.6% in FY04. FY04 witnessed the impacts of easy monetary policy to incite aggregate demand which contributed to rising inflationary pressures in the economy.

SBP had to pursue accommodative monetary policy stance until January 2005, by raising cut-off yield on benchmark 6 months T-bill early in FY04, complemented with administrative measures. SBP did not want to disturb economic growth; she tried to maintain trade-off between the growth and inflation. Accommodative response of central bank was due to the fact that the inflationary pressures were caused by supply-side, driven by the excessive domestic demand, which were supported by rising food inflation because of low performing commodity producing sector. Along with gradual increase in cut-off yield on 6 months T-Bills, administrative steps were taken which include allowing imports of food items from India and subsidized sale of necessary food items through utility stores.

Central bank adopted tight monetary policy from accommodative stance during 2H-2005. In response to the signs that economy may over heat, SBP raised its discount rate (for first time since November 2002) in April 2005 by 150 basis points from 7.5% to 9% backed by moping up liquidity through Open Market Operations (OMOs). As a result of these measures, both core as well as CPI inflation started downward trend at the start of FY06 but strong demand and rising international oil prices at that time had potential to dilute the impact of monetary stance because inflationary expectations hardened.

Pakistan's economy continued same momentum in FY06 with real GDP growth of 6.6% and made Pakistan third fastest growing economy in the region. Impressive growth increased hassles because of persistent rising fiscal and current account deficits, stagnant tax base, persistent inflation pressures and current account deficit posed serious threats to macro economic stability.

SBP tight monetary stance (since mid 2005), to curb the impacts of years of expansionary monetary policy, started producing results and helped government to achieve its target CPI inflation. The SBP had to continue tight monetary policy during FY06. The discount rate remained unchanged at 9% during IH-FY06. SBP improved its transmission of the policy rate by moping up the excess liquidity from inter-bank market and drive the Repo rates close to discount rate.

If you analyze the monetary policy objectives, they have been changing from maintaining exchange rate before 2000, to growth stimuli in 2002, to contain inflation with balance growth since FY05 till date. In 2H-05, SBP was successful in decelerating inflation along with growth in broad money (M2) supply, which was higher than the target. Main reasons were private sector credit growth and government spending on social and infrastructural spending and rehabilitation of earth-quake hit areas, which were acting like filing hot air in balloon, forced SBP to raise interest rates to contain incremental pressures. Along with this, imports and oil prices had been increasing which put burden on current account.

State Bank Pakistan raised policy rate by 50bp to 9.5% for 2H -06. Because growth in public expenditure was higher than the growth in revenues, which was evident from declining trend in tax to GDP ratio, shows poor tax mobilization efforts. Growing requirements for subsidies in the wake of soaring international oil prices, higher interest payments on domestic debt and increased development costs were the main reasons for escalation in expenditures and government's borrowing from banking sector. SBP kept discount rate at 9.5% but started increasing yield on T-bills and PIBs to signal rising interest rate.

Still the key challenges remained intact like rising food inflation, soaring international commodity prices, unanticipated reserve money growth which was pushing up aggregate demand (due to growth in inflows, government borrowing pattern, refinancing requirements) and current account deficit. Keeping in view all these challenges, SBP raised policy rate by 50bp to 10% in 1H-FY08, &7% on short term deposits and Zero rating CRR on long term deposits.

Monetary stances have not been productive yet as the food inflation continued hiking to the north. Situation aggravated further, headline inflation increased to 8.01% July-Dec FY08, due to hiking food inflation. Whilst, government borrowing from SBP was on rise which was highly inflationary in nature, as a result 19.3% reserve money growth was evident. In response to it SBP, in her recent monetary policy statement, raised policy rate by 50bp to 10.5% accompanied with increase in CCR to 8% on DTL of less than one year. SBP is continuously defending interest rate hike by saying if SBP had not pursued tight monetary policy, food inflation would have been higher than what it is today. It will be highly effective if government takes supply side measures to fill gap between demand and supply.

Now the questions arise, why food inflation has been increasing, though bumper crops resulted last period? Will interest rate hike help in achieving desired objectives? No one can answer these questions at this juncture. One thing for sure, it's totally at SBP and Government's part to ensure that the loans taken by borrowers are not being misused for hoarding wheat, sugar etc. Otherwise these measures will increase the miseries of common men and could hamper economic growth in long run.

WAY OUT

Current monetary policy of central bank does have short term benefits but it will surely hurt economic growth in long run. Monetary policy will definitely curtail lending capability of commercial banks but at the same time it affects almost all majors sectors of economy like textile, private sector, banking, equity markets. The best strategy would be to bring harmony between fiscal and monetary policy by SBP and government. Along with it government should retire amount owed to central bank in intervals and should diversify it financing base by issuing Euro Bond, PIBs and new innovative NSS with attractive returns, and long term strategy should be to improve tax collection system.

ECONOMIC INDICATORS

INDICATORS

2001-02

2002-03

2003-04

2004-05

2005-06

2006-07

2007-08 (JULY-DEC)

Discount rate

14%

7.50%

7.50%

9.00%

9.00%

9.50%

10.00%

Trade Balance (Billion $)

-1.2

-1.06

-3.28

-6.21

-12.11

-13.53

1.02

Workers Remittances($Bn)

2.39

4.24

3.872

4.17

4.6

5.49

3.06

Forex Reserves (Billion $)

6.43

10.72

12.33

12.61

13.14

15.18

15.02

Stock Exchange Index

1520

3402

5279

7450

9,989

13,772

14,075.80

GDP Growth

3.60%

5.10%

6.40%

8.40%

6.60%

7.00%

-

Inflation

3.54%

3.10%

4.50%

9.30%

8.00%

7.77%

8.01%

Agriculture

0.10%

4.15%

2.43%

6.48%

1.58%

5%

-

Manufacturing

4.50%

6.90%

14.01%

15.51%

9.97%

8.45%

-

Commodity producing sector

1.37%

4.19%

9.29%

9.45%

3.42%

5.98%

-

Services

4.76%

5.22%

5.84%

6.59%

6.27%

8.45%

-

Investment

3.19%

10.66

14.45%

32.63%

32.27%

21.31%

-