Pakistan’s central bank announced on Saturday that it would keep the policy rate unchanged at 12 per cent for the next few months in order to contain expected inflation in the second half of the fiscal year. The central bank had in an earlier decision cut the policy rate by 200 basis points, a decision that was welcomed by the private sector and investors alike. However, the State Bank of Pakistan is in a precarious situation where traditional economic paradigms have failed them. The contractionary monetary policy employed by the Central Bank has failed in serving its due purpose. Inflation remains high, while crowding out of the private sector is choking business and industry. Private sectors invariably require stimulus through the economy and this can be provided in the form of easy access to finance, pragmatic government policy and low interest rates.
Foreign investment assists in the formation of human capital, leads to international trade integration and aids in creating a conducive environment for businesses. While traditional economics dictates that raising interest rates control inflation, this policy has not worked in Pakistan where only food inflation in the last year propelled to a massive 45 per cent. Excessive borrowing from the SBP is diluting interest rates leading to crowding out of the private sector.
Therefore, instead of increasing the supply of credit to the private sector, the authorities have been financing unproductive expenditures through excessive borrowing. A state bank report mentions how policy makers have been effective in containing their spending by cutting down on ‘development expenditures’.
The State Bank further notes in their report that inflationary pressures have accumulated mainly owing to the “lagged impact of government borrowings from SBP, frequent upward adjustment in utility and POL prices, increase in commodity; and rising house rent index.” If one were to scrutinize the situation, it would be easy to conclude that inflationary challenges are inherently supply side constraints that can be dealt with even in the face of an expansionary fiscal and monetary policy. In the recently released report of the SBP the external account posted a deficit of a mammoth 1.7 billion dollars during Jul-Nov FY’12 compared to a surplus of $100 million in the corresponding period last year. The Central Bank has been brutally honest in its observation of the emerging scenario. “Although deterioration in current account was on the cards, the timing and magnitude was unexpected.
This larger than expected worsening was mainly concentrated in the month of Sep 2011 when simultaneous surge in trade deficit and fall in current transfers led to over a billion dollar deficit in the current account during this month alone,” the recently released first quarterly report of the SBP states. With foreign aid drying out, the SBP has had to rely on drawing from the foreign exchange reserves to curb the external account deficit. On account of debt repayments and absorbing the external account deficit, Pakistan’s foreign reserves declined to 16.69 billion dollars in the week ending Feb 3, compared to a record 18.31 billion dollars in July. With Pakistan’s oil prices linked to the international crude oil prices, it is expected that inflation while still under control at 10.10 per cent year on year in January will rise more than projected. Pakistan has even opted out of the IMF programme where the latter expressed concern over the lack of progress in fiscal reforms.
While the State Bank of Pakistan can go all out in its efforts to control inflation and try to manage the brewing economic disaster, the situation cannot improve without concerted efforts to prudentially manage fiscal affairs. The ramifications of the decision from the State Bank to keep the policy rate at 12 per cent may be justified in the short term; however, this will merely spell disaster in the coming months. Allow me to explain my understanding of the situation at hand. While the problems may be many, it is high time for the SBP to believe in omens. And, with the preferential trade agreement with the EU to be implemented by March, it is a wonderful opportunity for the powers that be to facilitate exporters and the industry to ensure penetration in the European Market.
By resolving the issues of the domestic industry, and providing them with a level playing field against its competitors, Pakistan can tap into the opportunity and significantly increase exports to the EU market. Other similar opportunities are on the horizon, with a plethora of markets promising great potential for local exporters. In the meanwhile what is required is of the Central bank is to facilitate the industry by providing them with easy credit. Stimulating the industry is the only way for Pakistan to move forward, and the stimulus must not be an injection of subsidy, but the establishment of an environment that attracts foreign investors and supports the local producers.
By keeping the policy rate fixed at 12 per cent, and not demanding of the powers that be to put their house in order and rein in the budgetary borrowings, the SBP is doing the people of the country a huge disfavour. How can the government handle the precarious situation? Well they should work in a transparent and competent manner to privatize the loss making Public Sector Enterprise that are gobbling up a humungous chunk of money and still making losses. So SBP, I think its time for you to believe in omens.
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