May 26 - June 01, 2008

During the last one year, central banks in many developed economies have significantly cut their respective policy discount rates in order to stimulate economic growth in the presence of turbulent global financial and economic settings. As against this the State Bank of Pakistan has decided to go opposite to the general trend. It has taken stringent measures to contain demand to counter increasing inflationary pressures in the economy.

For considerably long period economists and analysts have been arguing that the current inflationary pressure in the country is driven by higher food and fuel prices and monetary tools cannot have much impact in curbing these pressures. In addition they argue that the impact on core inflation will also be partial, considering that currently the rise in core inflation mirrors the "second round" effect of increasing food and fuel prices.

Analysts say that the overall impact on headline inflation has been minimal taking into the account the persistent hike in international commodity prices. However, the severity of the monetary tightening measures can bring core inflation down due to an expected cut in consumption. The measures taken by the central bank may have helped in draining some liquidity out of the system but has also resulted in a direct increase in KIBOR rates.

More importantly, this has an impact on the aggregate demand, which is yielding lower than estimated growth rates. The sustainability of the current policy rates will essentially depend on the fiscal stimuli likely to be bought forward in the upcoming budget.

The prevailing situation is very complicated and there cannot be any single solution to resolve the current melancholy.

There are several aspects to the current challenges and none of them are without costs. First, the impact of inflation on the lower income group is devastating. There is an urgent need to assist this group. On the food price side, one of the key culprits behind rising inflation, the government has already announced some measures such as export ban on wheat and allowing private sector to import wheat. This may help in addressing shortages issue could do nothing to protect the low income consumer from price hikes.

The point has come when the government will have to issue wheat, rice and daal vouchers to households with less than Rs 6,000/= monthly income, as stated by certain analysts. This mean high cost in terms of the subsidy but it is a necessity. At the same time, this is an excellent opportunity to implement a database for this income group - to both curtail misuse and also enable future policy actions aimed specifically at this population segment.

It is necessary that duties on imported luxury items should be jacked up temporarily. There are provisions within the WTO to do this for a temporary period. It is a question of preparing a strong and well articulated case for such a measure. The raising of L/C margin for imports to 35% is a broad shot-gun measure. More specific luxury good import duties in the budget should be considered too.

Policy makers need to put on hold non-essential development outlays and redirect whatever resources are freed up, into significantly increasing acreage and yields across the board. Simultaneously, it is essential to take regulatory measures to improve governance and transparency at the storage and distribution levels to ensure that the farmer gets his fair share and the consumer gets a fair price at the lowest frictional cost. This is the most immediate area that will have a positive impact on next year's GDP growth, relieve inflationary and current account pressures, support employment generation and income of the most vulnerable segments of the population.

No policy measure can help unless one key decision is made freezing government's current expenditure at last year's budget level. All salaries must be frozen. No expenditures (except essential food subsidies) for current government operations should occur over the next three years.

Development funding to MNAs and MPAs for their constituencies must be halted as a bulk of these end up in personal pockets of contractors and consultants. Simultaneously, tax leakages via corruption, under invoicing and such practices have to be stopped with strong criminal convictions for those found guilty. The issue of poor governance and corruption costs the treasury anywhere between Rs 60-100 billion a year. This money can be used to help the poorest segment of our society. And this can be done immediately if there is the will and sincerity on the part of the government.

It is challenging time for the country as a whole. It is blessing that this is a resilient nation. Policy planners will have to work hard and learn from past failures. Similarly, the investors must adjust to the new realities - but not emotionally or in panic. They need to step back and assess both the broader macro environment and the likelihood of various scenarios unfolding going forward. This is no rocket science, it is logical thinking.

Going forward, what are the likely Political and Economic Scenarios and how can investors position themselves depending on the probability of occurrence they assign to each scenario. Of course, there can be many different scenarios than those highlighted below. But for the current discussion, to keep things straight forward, lets' explore some possible scenarios thematically.

Reportedly, the primary purpose of this monetary tightening has been to reverse the monetization of the federal government deficit and provide support for the Rupee. It is likely have very limited impact on next-twelve months' inflation rate as the dice in that respect has already been rolled. This actually is a post-facto response which may appear to be the only course of action left, from one perspective. But it is putting too much burden on monetary policy to address what is really a poor fiscal governance and structural issue. A close analysis shows that politically motivated inaction after last year's budget gave government borrowing the first thrust.

This was followed by an incredible level of irresponsibility during the Caretaker Administration when government expenditure exploded. Why is this analysis not brought before the public in detail on a month-by month basis since July 2007, with specific heads of accounts where government expenditure occurred?

Fiscal irresponsibility is the cause of this crisis and the solution lies with fiscal policy and not monetary policy. Therefore, the dependence on monetary is unlikely to stop the rot. Unless a responsible fiscal stance is adopted and quickly, the crowding out effect is going to start showing up pretty quickly in the new fiscal year beginning in July 2008.