Report on:

Monetary policy of
Pakistan
Submitted to: Mirza Aqeel Baig

Submitted by: Ali Amjad (7213) & Faizan Sohail (7133)

MONETARY THEORY AND POLICY

SECTION “ A “
CURRENT MONETARY POLICY STATEMENT IN PAKISTAN
Building on initial gains in macroeconomic stability the economy is looking to further its traction
for sustainable recovery. Inflationary pressures have dampened but continue to persist, mainly
due to alignment of energy sector prices with market factors. Large Scale Manufacturing (LSM)
has consistently grown since October 2009 after contraction for almost 20 months but remains
fragile. Reduction in the external current account deficit has allowed SBP to rebuild foreign
exchange reserves, despite shortfalls in external financial flows. However, uncertainty has
increased in some areas, particularly the fiscal sector, with implications for the rest of the
economy, including monetary policy.

Although CPI inflation (YoY) has come down to 13.0 percent in February 2010, it is high and
exhibits persistence. After a low of 8.9 percent in October 2009, inflation slipped back largely
due to increases in electricity tariffs, adjustments in the prices of domestic petroleum products,
and administered prices of commodities like wheat. To which extent these factors will influence
other prices in the economy and expectations of inflation in the coming months remain difficult
to assess. Nonetheless, SBP expects the average CPI inflation for FY10 to remain close to 12
percent.

Despite presence of high inflation, crippling electricity shortages, and challenging security
conditions, domestic economic activity has picked up in recent months. A cumulative growth of
2.4 percent during the first seven months of FY10 in the Large Scale Manufacturing (LSM) is
encouraging. Sustainability of this trend in LSM and overall economic growth would depend on
improvements in the availability of electricity and security situation. In addition, this would
need supportive growth in private sector credit, which in turn depends on a reduction in the
scale of government and public sector’s reliance on bank borrowings.

The balance of payments position has improved considerably. The external current account
deficit has come down to $2.6 billion during July – February, FY10 compared to $8 billion in the
same period last year. This has allowed SBP to accumulate foreign exchange reserves, $11.1
billion as on 26th March 2010, and has facilitated stability in the foreign exchange market.
However, other developments in the external sector, such as Foreign Direct Investments (FDI)
and workers’ remittances, need to be monitored closely, especially when prospects of foreign
official flows remain unclear.

The key source of uncertainty, however, lies in the weak fiscal position. Burdened by significant
security related expenditures and shortfalls in revenues, keeping the fiscal deficit for FY10
within target would be challenging. Partial phasing out of subsidies and reduction in
development expenditures have helped in containing expenditures but has lead to surge in
domestic prices and is hurting crucial public sector investment. Similarly, increased Petroleum
Development Levy (PDL) receipts, due to higher oil imports, have cushioned the lower tax
revenues to some extent but have contributed towards inertia in domestic inflation. During the
remaining months of FY10, uncertainty regarding non-tax revenues on account of foreign
reimbursements and extent of remaining power sector subsidies adds to fiscal complications.

The financing mix of the fiscal deficit also seems uncertain. The external financing for budget,
especially the part pledged by the Friends of Democratic Pakistan (FoDP), has mostly been
elusive. Of the Rs110 billion net external budget financing received during H1-FY10, Rs93 billion
were provided by the IMF. With an understanding that this part of IMF money, provided in lieu
of FoDP flows, is for short term, the importance of the timing of external budgetary flows
cannot be overemphasized. Not surprisingly, therefore, government borrowing from the SBP
has been substantial in Q3-FY10. According to provisional figures the outstanding stock of
government borrowing from SBP (on cash basis), as on 25th March 2010, stands at Rs1240
billion, which is Rs110 billion higher than the quarterly ceiling limit.

With less than expected retirement of credit availed by the government for commodity
operations and commencement of the 2010 wheat procurement season, pressure will build on
the banking system resources. Continued borrowings by the Public Sector Enterprises (PSEs),
partly because of the lingering energy sector circular debt, are also straining systemic liquidity.
Further, the high infection ratio of credit to Small and Medium Enterprises (SMEs) at 22 percent
and Agriculture at 17 percent may lead banks to show reluctance to extend credit to the private
sector even when the pace of growth of incremental Non-performing Loans (NPLs) has slowed
considerably in the last quarter of 2009.

In this environment, with resources tied up in both commodity and circular debt and risk averse
behavior, banks will tend to negotiate higher rates on risk-free or government guaranteed debt.
For instance, the first issuance of the Term Finance Certificate (TFC) in March 2009 was priced
at KIBOR plus 1.75 percent, while the second issuance in September 2009 was at KIBOR plus 2
percent. Similarly, the rates for financing commodity operations were around KIBOR plus 2.5 to
2.75 percent. This reflects that banks are building in the cost of ongoing rollover, instead of
repayment, of outstanding credit. Thus, the attractively priced government borrowing may lead
to stagnation in private sector credit growth.
Government will have to revisit its commodity intervention strategy, sooner than later, so that
commodity operation requirements may go back to normal levels. Similarly, a complete
resolution of the circular debt would be essential. Apart from releasing banking system
resources and easing pressure on market rates, it will alleviate some constraints impeding
production of electricity in the country thus paving way for sustainable economic recovery.

Given the uncertainties pertaining to the fiscal and quasi-fiscal sectors, present stance of
monetary policy is striking a difficult balance between reducing inflation, ensuring financial
stability, and supporting economic recovery. An upward adjustment in SBP’s policy rate, at this
juncture, runs the risk of impeding the still nascent recovery, while a downward adjustment
runs the risk of fuelling an already high inflation. Hence, SBP has decided to keep the policy rate
unchanged at 12.5 percent.

DOES THE MONETARY POLICY FAULTERING IN

PAKISTAN?
The central bank has kept the discount rate unchanged for the next two months while
downside risks to economic growth have increased. It would appear that the current monetary
policy is merely designed to manage the balance of payments with soaring debts while
depreciating value of rupee against the dollar is curbing imports.

With high interest rates, falling rupee and credit squeeze, the State Bank has done very little to
stimulate domestic savings, investment, production and exports. And the inflation rate on
which the monetary policy is anchored, is once again on the rise.

The tight monetary policy is depressing domestic demand and retarding the economic growth
rate. The banks offer negative returns on the average deposit rates, discouraging savings. The
powerful banking lobby opposes moves by government to step up mobilization of domestic
savings (through National Savings Scheme) that is non-inflationary. High interest rates in low
growth environment are creating bad debts in the private sector and raising cost of government
borrowings, squeezing fiscal space for development of physical and social infrastructure

The monetary policy is stifling capital formation both in the public and the private sectors. And
despite slow growth, inflationary pressures are again building up in the economy, with steep
depreciation of the rupee pushing up prices of imported industrial inputs..

The commercial banks continue to profit from exorbitant banking spread. They prefer to do
trading in T/bills –– a risk-free investment — rather than finance investment in the commodity
producing sector. Banks are patronized at the cost of the real economy, turning the whole
financial system inefficient. The monetary policy is left to grapple with one banking risk after
another because the financial model is facing an organic failure.

Despite the tight monetary policy, the rupee is continuously sliding because exports are not
picking up and now there are indications that growing workers remittances have touched their
peak. In this area too, the growth trend may be reversed.

The improvement in the balance of payment position is debt-driven and has not come about as
a result of improvement in export earnings which is expected to drop by another one per cent
this year. . And the foreign exchange reserves are rising on the back of mounting debt inflows.
What is not realized by policymakers is that foreign loans are a short-term vehicle to manage
balance of payments and that foreign money can be no substitute for domestic savings. Unlike
foreign inflows, domestic savings help contain inflation. Countries with robust savings and
investment rates have high growth with low inflation.

Neither a tight monetary policy nor a sluggish economic growth would help bring any significant
amount of direct foreign investment that has sharply declined also because of domestic
security environment and drying up of liquidity in the global market The rupee must be
stabilized and interest rates must be lowered to attract investment and boost exports. By
allowing 100 per cent payment against the letter of credit on imported goods, the central bank
leaves an impression that the rupee’s slide would not be halted.

As long as the country remains in the IMF programme, (only countries in distress seek IMF
support), foreign investors cannot be tempted to look at the Pakistani market, unless very
lucrative business offers are made to them, e.g. rental power. This has been demonstrated
during Musharraf’s regime when policy makers moaned that no foreign investment was coming
though the country was under IMF’s programme. It was 9/11 that brought about the bubble
growth.

Finally, policymakers’ efforts to seek foreign assistance have not been easily forthcoming,
whether it is from the United States or the Friends of Democratic Pakistan (FoDP) group. The
only exception is the multilateral inflows coming from the IMF, World Bank and the Asian
Development Bank with all their attendant conditionality.

The developed world suffers from huge budget deficits, likely to persist for the next five to
seven years. The massive fiscal deficit, created by a bailout of the banking system, threatens a
double dip recession in the United States. More important, the current fragile economic
recovery in the industrialised world is a jobless one.

The government’s own track record on utilisation of foreign assistance is also a problem both
for the nation and the donors because, in the past, military rulers patronised the renter class.
How much interest the US has in the region after its possible exit from Afghanistan is an open
question. The FoDP has so far disbursed a mere $400 million from the pledges of $5.2 billion
made by the group in Tokyo. Hopes were first raised in press reports that much of it would be
in the shape of grants followed by revelations that the pledges would go to finance
development projects. Now in the Dubai meeting, it was stated, that the money would fund
public-private partnership in mutually agreed projects This would take its own time and would
not so easy to materialise. It seems that the FoDP has not moved beyond evolving concepts
that would govern the strategic partnership of the group with Pakistan.

Taking a long-term view of things, bilateral assistance cannot be relied upon on a sustained
basis. Over the years, it would become insignificant. Foreign direct investment benefits from a
fast growing economy and a sluggish growth would not attract foreign investors.
Over the past one year ending November, the average deposit rate of banks has declined by
0.25 per cent. The inflow of foreign money obviates the need for banks to raise domestic
deposits and for the government to raise tax revenue. Foreign money helps to exempt “sacred
cows” from taxation. It suits the lenders to keep the recipient under debt..

The rising risks to economic growth have not persuaded the central bank to cut discount rate
on January 30. Agricultural output may be much lower than this year’s target because of scanty
rains and low level of water in dams. The large manufacturing sector grew by a mere 0. 7% in
November. Exports are expected to decline by one per cent this year.

The performance of the commodity producing sectors remains lack lustre. Fiscal constraints
have forced the government to go for steep cut in development spending, the axe falling on
social and physical infrastructure that is needed to make the economy efficient and globally
competitive.

Countries which have focused on the real sector of the economy have achieved faster and
relatively more sustained economic growth. In Pakistan, unemployment is a more important
issue than inflation that can only be tackled by stepping up domestic savings, investment and
production. The monetary policy is discouraging capital formation in the commodity producing
sectors by making credit expensive and .imported inputs costlier.

No doubt high inflation rate is eroding the purchasing power of the consumers barring rural
areas where better wheat, cotton and sugarcane prices are providing some relief to consumers
in the countrywide. But in a country with rampant poverty, lower real income is better than no
income at all. The economies that are not focused on production are destined to falter. A
glaring contrast can be found between America, anchored on the global financial system, and
China— the world factory.