Monetary Policy 2007-08: more dilemmas than remedies

A.B. Shahid
05-08-07

The policy conveys the impression that SBP is seeking quick fixes to issues that defy such a remedy. It also reflects its dismay at the results of the measures adopted in FY 07 monetary policy (monetary expansion exceeding its target by a hefty 5.8 percent), and over-optimism about what the monetary policy can deliver in isolation in a country like Pakistan. While SBP's dismay at the results of FY07 has been appreciated unreservedly by market observers, they expected more realism in its approach proposed for FY08.

Raising the discount rate is the textbook approach to containing inflation but the option delivers only if the fiscal, trade and industrial policies converge for achieving common objectives, and the markets portray even playing fields for all players and, more importantly, the majority is conscious of the importance of self-regulation and social responsibility. This unfortunately isn't the case with Pakistan. Given these obstacles, and the fact that SBP has limited influence over the unorganised sector that is causing unabated escalation in food prices, it is overoptimistic to hope that the discount rate rise will cut down on inflation.

The likely outcome is a rise in inflation because hike in discount rate will push up interest rates impacting the entire supply chain in the organized sector, and raise the cost of doing business that is already eroding the industry's competitiveness - a fact manifested starkly by slowing exports and continuing high imports even though fractionally lower than FY06, yet steadily leading to closure of local businesses that are no longer competitive. The move could push up core inflation as well, which the SBP managed to bring down even in the otherwise problematic FY07.

Pakistan's real problem (admitted by SBP too) is high liquidity caused by a variety of foreign inflows, and government borrowing (bulk of which is short-term) that is largely financing current expenditure. FDI inflows representing sale proceeds of equity add to liquidity until their re-investment in productive assets. The same is true of sale proceeds of GRDs of public holdings. Bulk of the workers' remittances also adds to the stock of liquidity because it also fuels consumption. As for the foreign portfolio investment inflows, they always add to market liquidity.

SBP can't control inflation if all this is happening, and can't be blamed if it fails in controlling monetary expansion and the consequent inflation; blame there for lies squarely with the federal ministries of finance, commerce, industry and water and power. These ministries failed in gauging the demands the recent high GDP growth was bound to place on the physical infrastructure that is now proving inadequate for meeting the demand surge. It continues to discourage investors and they are now opting to invest in the far less problematic and quick yielding speculative trades.

This is evident from the upsurge in stock exchange indices and the level of trading thereon, and the astronomical rise in real estate prices. Hoarding too has now become an accepted business activity because no one is penalized for indulging in it. Europe and the US too are de-regulated markets but there, price fixing and cartelisation are punished severely. Latest example thereof is the $ 547 million fine imposed on British Airways by the regulatory authorities. In Pakistan, despite clear evidence thereof in several sectors, price fixing and cartelisation go on unpunished.

This scenario is exceptionally challenging for the SBP. Businesses are limping due to high cost of doing business and their large borrowings make them vulnerable to any rise in loan rates. At the same time, excess money is fuelling inflation. An appropriate course would have been to leave interest rates untouched but suck liquidity by hiking up cash reserves (CRR). SBP did up the CRR but without a strategic focus. Graduated CRR for deposits with over-a-year and 6-month maturity, another for saving, and 8 percent on current deposits would have been more appropriate.

A flat CRR ignores the reality that over two thirds of the banking sector deposit base is made up of saving deposits that represent the savings of nearly 85% of the country's population. With a flat CRR, banks may respond by cutting profit rates on saving deposits owing to the CRR-driven rise in the effective cost of these deposits. Such a response from the banking sector would further disappoint savers and embarrass SBP, which is already being blamed for the high banking sector spread that is hurting both savers and borrowers.

Deficiencies in the infrastructure and distortions in market practices are steadily diverting resources to the money market flooding it with liquidity that defies the usual strategies for containing it. We still don't recognise that the real cause of inflation is lack of interest in real investment because venture output cannot compete with cheap imports (especially from China) because of infrastructure-driven inefficiencies; until we address them, the money that keeps floating in the markets won't be converted into value-generating real investment and go on fuelling inflation.

We seem to be following the US that imports heavily and pays for its imports out of borrowed funds. Our concern for raising exports is limited to ministerial speeches. Measures announced in the FY08 monetary policy too don't build much hope either. Asking banks to fund 30 percent of the subsidized credit under SBP's export finance scheme will surely reduce market liquidity after recall of SBP funding to that extent. But doing so, SBP is relying on banks to provide subsidized credit; exporters doubt that this will happen, and fear about not getting requisite bank financing.

SBP has defended this decision by assuring exporters that banks have agreed to provide their share of subsidized credit and SBP will ensure that no exporter is refused financing under the scheme. Hopefully, SBP is aware of the often unpleasant surveillance and adjudication effort that living up to this promise will involve (perhaps, setting up a dispute resolution tribunal?). Doubts about SBP's ability to live up to its assurance arise from the changed psyche of the banking sector wherein there is little room for undertaking less remunerative but morally imperative initiatives.

In the context of cheap export financing, measures that envisage easier availability of a wider variety of exchange risk covers are indeed appropriate. But the fact remains that external borrowing will add to market liquidity. Similarly, the provision that permits deducting from its reserve-eligible liabilities an amount equal to the bank's share in export finance is strange, firstly, because not maintaining reserves on liabilities is imprudent for any bank and, secondly, not maintaining reserves will indirectly add liquidity to the market equal to the otherwise maintainable reserves.

SBP's promise to provide subsidized long-term finance (whose details are yet to be announced) for acquiring new plant and equipment is commendable. The yardsticks it employs to determine the "financial capacity and strength" of the Approved Participating Financial Institutions that will share in SBP's yearly disbursement limit for this facility, will be of great interest. The detail must also dwell on the criteria for exporter qualification besides the basic conditions (export of 50 per cent of out put or yearly exports worth US$ 5 million) that were disclosed in the monetary policy.

For instance, while assessing a proposal, how must banks judge its export potential and the permitted gestation period to reach the export target? Will this period be extendable, and if so, on what bases? How will the exporters failing to meet export targets be penalized? Will it lead to immediate recall of the entire facility or in parts, and at what stage will penal mark-up be applied? Because these projects will be based on a subsidized financing cost, this factor could abort the chances of commercialisation of the problematic among them, unless this possibility is provided for in the details to be released later.

Finally, market deregulation without putting in place an effective mechanism that obliges markets to adopt ethical practices can prove embarrassing; it can encourage players to cash-in on consumers' incapacity for verifying the fairness of deregulation-generated practices. After three and a half years of permitting loan pricing on floating mark-up rates we have discovered that flawed loan pricing too was partly fuelling inflation. Surely, all these years both external and Central Bank auditors did their job but since exemplary penalties were not levied on flawed loan pricing practices, the aberration continues to-date, and had to highlighted in the monetary policy statement.

The fact that excessive deregulation encouraged singular focus on profitability at the expense of social responsibility is proved by the fact that the monetary policy had to emphasize on increasing penetration of less profitable markets by requiring that Annual Branch Expansion Plans must provide for setting up 20 percent of them in rural/underserved areas. Also, that no charges be levied on the Basic Banking Accounts or for converting regular full service accounts into these accounts. That customers maintaining deposit balances below a bank's minimum should not be charged over Rs. 50 a month. Imposition of these measures through a sacrosanct announcement like the monetary policy reflects on the sense of responsibility of the banking sector.