PIDE MONETARY POLICY VIEWPOINT

INTRODUCTION
There is a serious threat that the Pakistan economy could get entrenched into a prolonged
and deep stagflation unless decisive and concerted action is taken by policy makers.
There are clear signs that at least in the foreseeable future the economy will witness low
economic growth and high double digit inflation - the classical characteristics of an
economy in stagflation. The real challenge therefore is to draw up a co-ordinated strategic
response to break out of stagflation by rekindling growth and checking inflation.
Regaining macroeconomic stability must remain of paramount importance as it is
essential for ensuring sustained growth. Yet it is important to emphasize that in the
current troubled socio-economic milieu economic growth that creates new jobs and
reduces poverty is equally vital not just for the economy but indeed the country.

It is in this context that PIDE’s Monetary Policy Viewpoint analyzes the latest September
29, 2010 State Bank Monetary Policy Statement in which it announced an increase in the
discount rate by 50 basis points to 13.5 percent from 13 percent for the second time this
year.

MONETARY POLICY STATEMENT (OCTOBER-NOVEMBER 2010)

Monetary policy management is one of the primary roles of the State Bank of Pakistan
(SBP). In line with SBP Act, monetary policy has to be supportive of the dual objective
of promoting economic growth and price stability. The SBP conducts monetary policy by
using money supply (M2) as an intermediate target. This target is set with the help of real
GDP growth and inflation targets set by the Government.

In its Monetary Policy Statement the State Bank highlights the following recent economic
developments which pose a serious risk in attaining macroeconomic stability:

High fiscal deficit resulting from increased government spending which would
further heighten inflationary pressures.
Floods have further worsened this situation.
Trade balance could come under stress.
Rise in Non Performing Loans (NPLs) of the private sector and expected
increased borrowing of the government.

Moreover, Monetary Policy Statement points to a number of factors that could raise
inflationary expectations. These include disruptions caused by catastrophic floods,

The viewpoint was produced by a PIDE team led by Dr. Abdul Qayyum and included Mr. Muhammad
Javed and Mr. Kashif Munir.

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expected increase in electricity prices, introduction of the reformed GST and continued
reliance of the government on borrowings from the SBP.

It is in light of the above mentioned facts that SBP has increased the discount rate by 50
basis points to 13.5 percent.

PIDE’S VIEW ON MONETARY POLICY DECISION

Currently SBP is using interest rate as an instrument of monetary policy to control

inflation. The SBP pursues a monetary target regime with broad money supply (M2) as a
nominal anchor to achieve the objective of price stability. The SBP sets a target of M2
growth in line with government’s targets of inflation and growth. This framework is
based on two key assumptions: first, there is a strong and reliable relationship between
the goal variable (inflation or real GDP) and M2; and second, the SBP can control growth
in M2.

Effectiveness of Interest Rate Channel

Since 2005 monetary policy has mainly relied on interest rate channel. This brings to fore
the question of the effectiveness of the interest rate channel as a transmission mechanism.
However, in Pakistan (and indeed in most developing countries) monetary policy actions
transmit their effects on macroeconomic variables with a considerable lag and with a high
degree of volatility and uncertainty.

The current monetary policy stance is silent about the issues of lags and the pass-through
effect of the policy rate to inflation. There is clear evidence based on empirical analysis
[see Khan and Qayyum (2007), Qayyum, Khan & Khwaja (2007)] that interest rate
influences inflation with a lag of 12 to 18 months and the magnitude of this impact is
very small. Indeed some studies (e.g. Khan, 2007) show that the relationship between
interest rate and inflation is positive.

The movements of interest rate and inflation between 2007-10 can be depicted in figure
1. It suggests a positive relationship between the interest rate and inflation although
clearly a number of other factors were at play. The coefficient of correlation is 0.688. It
implies that rising interest rate in recent years has little impact on dampening inflation
and there is no reason to believe that the situation has now changed.

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 Figure 1: Movements of inflation and interest rate

Interest Rate and Fiscal Deficit

Let us now examine whether the increase in interest rate would act as a deterrent to
increased government borrowings from SBP as the recent Monetary Policy Statement
appears to argue.

In fact it could further worsen the situation. The increase in interest rate would increase
interest payments on government debt which will cause an even higher fiscal deficit even
if we take into account higher profits of the State Bank. The truth is that the government
is borrowing beyond the agreed level from the SBP, and the SBP is not able to restrain
this level of borrowing. The likelihood then is that the government would finance the
higher deficit on account of higher interest payment by borrowing further from the
central bank. Borrowing from the SBP injects liquidity in the system through increased
currency in circulation. The impact therefore of a tight monetary policy stance is diluted
with this automatic creation of money which increases the money supply.

During 2008-09 the increase in discount rate increased the cost of borrowing from
Treasury Bill, Pakistan Investment Bond rate and National Savings Scheme. In this
period an amount of Rs 580 billion was spent on account of servicing of domestic debt
against the budgeted estimates of Rs 459.1 billion.

The fact is that easy recourse to increased borrowings from the SBP leaves little incentive
to the government to put its badly needed fiscal situation in order. And in this situation
an increase in interest rate can further worsen rather than improve the situation.

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 Monetary Policy and Real GDP Growth

If the increase in the interest rate neither helps to reduce inflation nor appears to act as a
deterrent to government borrowing then the real hit is taken by the private sector.

Higher interest rate increases the cost of borrowing of the private sector which
discourages the demand for private sector credit. When the demand for private sector
credit decreases, the level of private investment falls which adversely affects economic
growth.

Monetary Policy and Credit to Private Sector

There is a strong negative correlation between discount rate and credit to the private
sector (-0.84 over the period August 2009 to August 2010). When the Monetary authority
reduced policy rate by 100 basis point from 14 percent to 13 percent in August 2009 and
then further to 12.5 percent in November 2009, credit to private sector increased
gradually during this period. In August 2010, the Monetary authority again tightened
monetary policy by increasing the policy rate by 50 basis point from 12.5 percent to 13
percent which is again negatively affecting the credit to private sector as can be seen in
Figure: 2.

Figure 2: Interest Rate and Credit to Private Sector

Exchange Rate

If in the current situation increase in interest rate is neither slowing inflation nor curbing
government expenditure but just slowing down the private sector the only possible reason
not made explicit by the SBP in its Policy Statement is that this measure could help
stabilize the exchange rate.

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Here it is important to make a clear distinction between exchange rate management and
monetary policy management.

It is now well established that it is not possible to achieve simultaneously exchange rate
stability, monetary independence and free movement of capital (the so-called “Impossible
Trinity”). Trying to stabilize the exchange rate would mean a loss of monetary policy
autonomy even if in the very short-term high interest rates may prevent movement from
local to foreign currencies. In any case exchange rate policy should be determined by the
country’s competitiveness rather than artificially propped up through higher interest rates.

CONCLUSION

The strong message of the SBP through its latest Monetary Policy Statement for Pakistan
to put its fiscal house in order must clearly be supported.

What we have argued is that a tight monetary policy stance through increase in the
discount rate serves little purpose in the current conditions. Indeed, it only further
squeezes the private sector and discourages private investment which is already facing an
extremely difficult situation.

What is needed is an integrated fiscal cum monetary response which brings about
macroeconomic stability and helps spur much needed growth into the economy. Also
fiscal reforms are easier to undertake and yield desired results in a growth promoting
rather than a depressed economic environment.

REFERENCES

Khan, M. Arshad and A. Qayyum (2007), “Trade, Financial and Growth Nexus in
Pakistan”, Economic Analysis Working Papers, Vol. 6, No. 14.

Khan, Sajawal (2007), “Channels and Lags In Effects of Monetary Policy’s Transmission
Mechanism: A Case of Pakistan”, Unpublished Ph.D Dissertation (Pakistan Institute of
Development Economics, Islamabad).

Qayyum, A. Sajawal Khan and Khawaja M. Idrees (2005), “Interest Rate Pass-through in
Pakistan: Evidence from transfer Function Approach”, The Pakistan Development
Review, Vol. 44, No. 4, pp. 975-1001.