|The article was published in the Money Matters July 1, 2013|
|By M. Ali Kemal|
Conduct of monetary policy is a key challenge faced by the State Bank of Pakistan (SBP) since several trade-offs are associated with one policy change. Among these, output inflation trade off takes the top spot in the short run. A recent nine percent decline in discount rate by the SBP is meant to encourage the private sector to avail credit at a lower transaction cost. This move prompts researchers to ask - are investors going to invest since the energy crisis and security are still key constraints keeping industrial plants from producing at a low capacity, as revealed in the latest issue of PIDE Business Barometer? Moreover, since June 2012, discount rate has declined from 12 percent to nine percent to boost investment whereas private credit has not increased.
The business community has asked the government to reduce discount rate to eight percent but as per its policy since 2006, the SBP does not decrease or increase interest rate by more than one percent. It is possible that if SBP is following the government guidelines of reducing discount rate to eight percent, then before the end of this year, it will implement the above-mentioned change. As a result, if investor’s response of taking credit becomes positive, it will generate employment and higher output/GDP growth.
Although this is a short-term gain and will result in higher inflation in the long run, it will boost the economy in the short run, which may generate other economic activities - especially those in the informal sector.
If private credit increases as a result of a decline in interest rate, it will be difficult to curtail inflation at the announced level of 9.5 percent unless certain additional measures are enforced. Thus we can expect to see double-digit inflation. If this happens, the government may need to increase interest rate to curtail inflation. Resultantly, private credit will decline, which in turn will dampen growth.
Since the SBP has been following inflation to adjust interest rate (not the other way around), especially for the last three years, this was a rather difficult decision for it. Significantly, this is not the SBP’s decision alone; the government also bears responsibility for pushing it forward.
In the literature of macroeconomics (recently popularized as monetary economics), several policy measures are discussed, which are conducted by central banks in the world. The greatest debate among these policy measures is whether we should follow some rules or go with discretionary policy. Some of these policy rules are ‘appointment of conservative central banker’ whose sole objective is to reduce inflation as much as possible, inflation targeting, monetary targeting, interest rate targeting and exchange rate targeting. The main objectives of these policies are: monetary stability, lower inflation and price stability.
Theoretically speaking, the central bank should look at the Friedman k-percent rule of constant money growth each year, Mundell’s assignment problem, (use of money supply only if exchange rate is flexible) and/or Taylor rule. Contrary to the rule-based policies, discretionary policies are necessary, according to Keynesians, and are more popular especially at the time of depression or economic downturn.
The above-mentioned, rule-based policy measures have different pre-requisites which need to be satisfied to achieve results. Lower fiscal deficit is among the pre requisites which are mostly ignored in Pakistan and hence authorities need to print more money or finance it through banks. These actions result in higher inflation and crowd out private investment.
Can the SBP follow some rule-based monetary policy, be it any one of the policies discussed above? In the current scenario, it seems unlikely that it can operate independently. The SBP does not have autonomy and is controlled by the government, especially when it is confronted with a higher fiscal deficit. To achieve short-term political gains, employment policies are announced by lowering interest rate, which eventually result in higher inflation in the long run. Moreover, if the SBP along with the government is keen to boost economic growth in the short run, then discretionary policies are better than rule-based policies.
A fiscal deficit target of 6.3 percent of GDP with 4.8 percent growth seems unattainable if the government will not get the required amount of projected tax revenues. If this is the case, the government needs to borrow more and it will be interesting to note the source of financing. If it asks the SBP to print more money, it will lead to excessive inflation. On the other hand, borrowing from the scheduled banks will crowd out private investment. Thus, both the modes of financing will not give the government the results it seeks.
After discussing all the problems faced by the SBP and the government, it emerged that: (1) Since private credit did not pick up in the last one year, even though discount rate was reduced by 2.5 percent, it is ambitious to expect private credit to grow until the constraints are completely wiped out or discount rate declines to a level that suits investors, such that real interest rate becomes negative; (2) Fiscal cliff is decided in the budget and borrowing procedure is identified clearly; (3) State Bank autonomy is necessary to conduct monetary policy (operational autonomy); (4) While making monetary policies one should think in the long term; (5) In the present times, given slower economic growth and high fiscal deficit, all three stakeholders, the Planning Commission, SBP and FBR should make budgetary and monetary policies which are consistent. Above all, let’s give professionals (no bureaucrats no politicians) in these organizations a chance to make consistent economic policies.
The writer is a research economist at PIDE