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Tight monetary policy still targets inflation

It will raise the cost of doing business, increase cost of production and in fact may raise consumer prices to add fuel to the raging food and other prices. The business immediately reacted saying it will mean higher cost of production. What prompted the re-enforcement of TMP? Heavy government borrowing even against the central bank warnings, and, to a lesser degree, check lending to the private sector. Cheap lending in the past has led to hoarding of food items including wheat adding to rise in consumer prices.

The new Tight Monetary Policy (TMP) is effective February 1, the State Bank of Pakistan (SBP), the central bank, has announced. It has two elements: the Discount Rate (DR) goes up 0.50 basis points (bp) to 10.50 per cent.

The other element — the Cash Reserve Ratio (CRR) goes up by 100 basis points to eight per cent directing all banks to maintain more cash in reserve with the SBP.

Spiralling inflation more alarmingly the food inflation that is officially estimated at 16 per cent, but by independent economists at close to 20 per cent, forced the SBP to strengthen its TMP.

Dr Shamshad Akhtar, Governor SBP, announcing the new TMP said, it will be revised in six months — at the start of the new fiscal 2009 on July 1. Justifying strengthening of the TMP she said, in the face of the rising main inflation 'Consumer Price Index (CPI) — and core inflation "it was challenging to manage the monetary policy."

"It was the SBP's success to bring down the core inflation to three per cent until, May 2007. However, it then started rising to reach 7.2 per cent in December, 2007," she says.

Dr Akhtar accused the government of "breaching its borrowing limits." "The heavy government borrowing is also responsible for rise in inflation over the last six months," she said.

At Rs509.7 billion government's tax collection fell short by Rs29.8 billion from the July-January target of Rs539.5 billion.

The government borrowing between July 1 and January 19, SBP said, rose to a record Rs237.1 billion to fill the widening budget deficit. It was partly due to the rising subsidy on oil sales to consumer as international prices soared.

"The government's heavy reliance on borrowings from SBP has the potential of sharply accelerating reserve money and thus M2 growth."

A higher annualised M2 growth of 19.2 per cent has already increased the supply of broad money from Rs199.8 billion, reached last year, to Rs. 234.4 billion in the like period of this year.

Dr Akhtar says, "An M2 growth target of 13.7 per cent for fiscal 2008 will be quite challenging unless immediate corrective policy measures are taken to reduce, significantly, the excess borrowings from the central bank."

Another warning signal is a 3.7 per cent depreciation of the rupee against the US dollar between July 1 and January 19 an additional contributing factor to inflationary pressures in the coming months, besides eating into the official forex reserves.

Dr Akhtar points: "The impact of the political uncertainty and pressure of government borrowing on the financial system continues. The private sector credit managed to grow by 10.4 per cent during July 1 to January 19, 2008 as compared to 10.2 per cent in the like period of last year."

SBP also maintains "the less than expected net inflows in the portfolio investment due to uncertain domestic environment was a drag," and have widened the current account deficit. The prospects for such inflows, including Eurobonds, GDRs and proceeds from the sale of state-owned enterprises, which were needed to finance external account deficit depends on an improvement in the domestic and international environment.

"The increase in the DR will not have any impact on the economic growth outlook which will remain around 6.5 per cent to 7.2 per cent for the current fiscal 2008," she says. But it can deteriorate if the current anti-government turmoil goes on in run up to the February 18 elections and in the post-election period.

The governor also says the decision to strengthen the three year long TMP was taken "to siphon off excess liquidity from the financial system which was mainly because of higher inflows of forex through remittances." The Home remittances from the Overseas Pakistanis, including those working in Dubai, UAE, Saudi Arabia, US and UK, are moving ahead of fiscal 2007. The total remittances received during July-December 2007 were $ 3.066 billion, up 19.4 per cent from the like period of last fiscal. Remittances for the full fiscal 2008 are projected at $ 6.0-6.5 billion compared to $ 5.8 billion in 2007, according to SBP.

The government and the business has criticised the latest DR and CRR hike. "The cost of doing business for the manufacturing sector will, increase," businessmen and members of the Karachi bourse said. Cost of borrowing to purchase bourse stock market shares on credit will also go up. The financial costs of textiles, cement, fertilisers, and some other industries, the main borrowers from banks, will rise. But oil and gas exploration companies are unlikely to be affected much.

The new policy will encourage banks to seek longer-term, deposits, as against the current account. Banks will have to raise profit rates for depositors, which will partly erode their profits.

But, there is disagreement between the central bank and the government over the new TMP. Dr Salman Shah, interim Minister for Finance, and member of the eight-year old economic team which is now accused of failed policies that created critical nationwide shortage of food, electricity, natural gas, and even water, disagrees with the central bank's TMP.

SBP is "going against the tide, as in the whole world there is a trend of reducing the interest rates. However, here the central bank has raised the discount rate by 50 basis points, although not too high, but even then it will retard economic activities, Shah says.

Dr Shah was member of the pro-growth team, which ignored equity and welfare of the poor. Many elements of its high growth policies, have now started unravelling. It is also accused of fudging growth rate, inflation and poverty numbers.

"The central bank and the government cannot defuse the inflation bomb as 70 per cent of commodities included in Consumer Price index cannot be controlled because the prices of oil products, palm oil and food items are also beyond their control.

Pakistan imports POL and palm oil. Therefore, the state bank should continue with the earlier monetary policy for the remaining months of the current fiscal 2008," Shah insists. However, the test of the pudding — and impact of the new TMP — will be known by June 30 when the current fiscal ends or even earlier.