DOUBLE EDGE KNIFE EFFECT WITH INCREASE IN BOTH INFLATION AND INTEREST RATE
SAAD ANWAR HASHMI
July 16 - 22, 2012
Pakistan is in a crisis situation where the government has not been able to increase the tax base or avenues to increase exports in order to help mitigate the budgetary deficit. To finance the expenditure, the government has resorted to either borrowing from World Bank or Asian Development Bank being international advances denominated in US Dollars along with borrowing from the banking system offering an attractive rate of return which considered risk free. With devaluation of the exchange rate against the dollar, the net outstanding in rupee terms against the US denominated loans automatically increases the debt to be repaid.
During the current year, the outstanding stock level of government securities increased to Rs. 1,660 billion by May 2012. The year-on-year growth in the private sector credit was only 4.2 percent. Since government securities yield a healthy risk free return, banks continue to prefer financing government's deficit through investment in fixed income securities rather than focus more on taking risk and extend private sector credit declining the investment to GDP ratio. Banks are considered financial intermediaries bridging the gap between borrowers and lenders through demand of money. Since banks are not seeking new relationships both through retail and corporate advances primarily managing the current portfolio, the role of acting as financial intermediaries is slowly fading away. Residual funds or deposits are placed in short term government securities with tenors ranging from 3months, 6months and 1 year to yield a healthy risk free return as part of banks ongoing strategy. Recent T-Bill auctions have yielded between 11.8 percent to 12 percent return which forces banks to be resilient with such investments rather than lending to consumers or private sector. The current scenario results in crowding out and eventual increase in lending rates. SBP has time and again in every monetary policy review and decision has encouraged the government to increase the tax base and limit borrowings from the banking system which results in an increase in interest rates for corporates and consumers. According to an amendment in the State Bank of Pakistan Act 2012, government borrowing from the SBP is required to be repaid at the end of each quarter and the existing stocks to be retired within eight years starting from this fiscal year. This unfortunately is not being complied with by the government whereas maturing bills are replaced with new auctions thereby keeping the net effect of borrowing from the banking system same.
In addition to interest rate, another impact of government borrowing is inflation with excess flow of money in the economy which counters SBPs efforts to curtail inflation. There has remained significant speculation on Monetary Policy decisions by SBP based on economic aggregates to define the ongoing tools to be adopted to control inflation. The international oil prices continue to be volatile. Inflation in Pakistan has remained in double digits and not expected to decrease to single digits through CY12 keeping with devaluation of currency along with high cost of inputs. The core cause of concern for SBP is government borrowing which have yet to be reduced. If oil prices decrease, any such decrease will be negated through the devaluation of rupee against the dollar which is likely to increase the import bill and causing inflation. CPI as on May 2012 stood at 12.30% with electricity, fuel and gas accounting for 29.41% of the CPI. Based on the latest Monetary Policy decision, SBP has kept the policy rate at 12%. During the first eight months of FY12, the external current account deficit was US Dollar 3 billion while the net capital and financial account receipts were only US Dollar 187 million. A source for liquidity pressures in the economy is sluggish economic growth and foreign direct investments which could substitute low tax base. SBP stressed that the government must devise fiscal and energy sector reforms and plan foreign financial inflows to mitigate uncertainty and pressure on reserves.
Based on the latest Inflation Monitor report by SBP issued in April 2012, inflation is on a rise among all income levels and across most commodities and products used for daily consumption. Major increases have been witnessed among wheat, pulses, eggs, milk, sugar, fruits and vegetables which will continue to be volatile. In addition to government borrowing, the reasons for inflation in Pakistan are numerous some driven through supply while others driven through demand side pressures. Despite measures undertaken by the SBP to control the money supply, the government remains the single largest borrower from the banking sector through fixed income securities for deficit financing which again increases inflation. Budget deficit resulting in SBP borrowings is expected to remain below 5% of GDP though FY12-13. Pakistan with one of the lowest tax base in the economy.
The challenge for SBP with the Monetary Policy is to reduce inflation and encourage private sector lending alongside an attractive rate of return for depositors to counter rise in inflation. The Monetary Policy cannot work in isolation considering external shocks e.g. international oil prices, recessionary impact, devaluation in interest rates or government borrowings. Pakistan is a net importer therefore any devaluation in the exchange rate against the dollar will make imports expensive and put further pressure on the reserves. Though exports due to such devaluation are expected to grow, however considering rise in input cost, such differential may be negated making prices unattractive for the export markets.
To curtail inflation and finance government budgetary deficits, SBP's decision on the monetary policy alone cannot work in isolation unless such policies work hand in hand with fiscal decisions to increase tax base and eliminate transactions which run parallel to the economy. The government's total expenditure to GDP is 19 percent whereas revenue to GDP is 12.5 percent creating a mismatch which needs to be filled through tax base rather than borrowing from the banking sector. Though decisions to maneuver the economy also rests in the hand of the government, what will eventually help resolve the current situation is high degree of integrity and accountability for public service across the board to address every issue faced by the people in the economy to better their lives.