MONETARY POLICY As the economy begins the last quarter of current fiscal year, SBPs monetary management continues

to play its part in balancing the implications of multiple challenges faced by the economy. The primary consideration remains bringing inflation further down as it has persistently remained in double digits in the last few years. Ensuring smooth functioning of the payment system and financial stability is also important given the current stressed liquidity conditions in the market. Similarly, elevated international oil prices, weak quantum of exports, and insufficient foreign financial flows require careful management of the external position. Last but not least, the consistent decline in private investment is also an important factor in formulating the monetary policy strategy as it impacts both the medium term inflation, growth and employment prospects. Given limited set of instruments, not all these challenges can be effectively tackled by monetary policy alone. There are bound to be tradeoffs involved among these competing considerations. A supporting fiscal strategy and an active economic reform agenda is critical to deal with some of the structural issues, in particular, low tax to GDP ratio and energy shortages. Most importantly, the economy needs a forward-looking approach to policy making with strict adherence to rules laid out in the legal frameworks, be it the State Bank of Pakistan (Amendment) Act (2012) or Fiscal Responsibility and Debt Limitation (FRDL) Act (2005). Following this approach is crucial in anchoring inflation expectations around the medium term targets of 9.5 percent for FY13 and 8 percent for FY14 as envisaged in the Medium Term Budgetary Framework (MTBF) of the government. In March 2012 the year-on-year CPI inflation was 10.8 percent and, given the current economic conditions, is projected to remain in double digits during FY13. Consistently growing government borrowing requirement from the banking system is a key variable that is adversely affecting the inflation outlook. Weak private demand, on the other hand, is one reason why inflation is not increasing sharply. Nonetheless, the size of fiscal borrowings and lack of investment is eroding the medium term productive capacity of the economy, contributing towards persistence of inflation in early double digits. Another risk factor that needs to be monitored closely for assessing inflationary pressures is the behaviour of international oil prices. The current year government borrowings for budgetary support have been Rs373 billion from the scheduled banks and Rs218 billion from the SBP during 1st July 30th March, FY12. The year-onyear growth in these borrowings turns out to be 56.5 percent and 18.5 percent respectively. The year-on-year growth in the private sector credit, on the other hand, was only 4.2 percent and that in total deposits of the banking system was 17.4 percent during the same period. Thus, despite a decent growth in deposits, the banks continue to prefer financing the fiscal deficit as opposed to searching avenues, taking risk, and building partnerships to facilitate credit to the private sector. The cost to the economy is visible in terms of a decline in investment to GDP ratio to historically low levels and stagnant economic growth that is considerably lower than the economys potential. If a revival in private sector credit and growth prospects is to take place, a pertinent question in the current circumstances is: how would the government rollover its maturing short-term debt and raise additional financing while simultaneously retiring its borrowings from the SBP? With shortfalls in external sources, the most likely avenue will be more borrowings from the SBP. The inflationary implications of this scenario should not be underestimated. However, according to the recent State Bank of Pakistan (Amendment) Act (2012), government borrowing from the SBP is required to be repaid at the end of each quarter and the existing stock is to be retired within eight years. In case of not observing these provisions, the Act also stipulates that the federal government will submit a statement to the Parliament giving detailed justification. Adherence to this legal requirement, without serious adjustment in the fiscal position, would lead to significant injections of liquidity by the SBP to keep the payment system functioning and financial markets stable. But, SBP is already injecting substantial short term liquidity in the system, Rs200 billion as of 13th April 2012, which is being continuously rolled over. The permanent nature of these injections also potentially carries inflationary risks. Thus, simultaneously meeting the legal requirement of zero quarterly borrowings from SBP, scaling back liquidity injections, effectively

anchoring inflation expectations, and creating space for the private sector, could prove to be a much more difficult task than appreciated. Government borrowing requirements are not the only source of liquidity pressures. With a gradually rising external current account deficit and consistently declining foreign inflows, the SBPs foreign exchange reserves are on a declining path. During the first eight months of FY12, the external current account deficit was $3 billion while the net capital and financial account receipts were only $187 million. Not surprisingly, SBPs liquid foreign exchange reserves have declined to $11.8 billion by end-March 2012 from $14.8 billion at end-June 2011. These external sector developments are exerting downward pressure on rupee liquidity as indicated by a 21.4 percent year-on year decline in Net Foreign Assets (NFA) of the banking system by end-March 2012. Thus, some rupee liquidity injection and increase in reserve money is required to facilitate normal transactions taking place in the economy. Further, SBPs operational monetary management framework sets the short term interest rate or the price of liquidity based on broad macroeconomic considerations such as likely inflation path relative to the announced target. The requirement of liquidity and thus growth in reserve money is residually determined and provided to ensure smooth functioning of financial markets. The SBP cannot simultaneously set both the interest rates and money growth. The challenge is if the underlying behaviour of a significant user of money does not respond to interest rate signals, then monetary policy would become ineffective in achieving its objectives. Given substantial external debt payments, declining trend of export quantum, elevated international oil prices, and weak financial inflows, the external position is likely to remain under pressure in the remaining part of FY12 and FY13. Similarly, provisional financing data indicate that the fiscal deficit may have reached 4.3 percent of GDP during the first nine months of FY12. Given the last quarter seasonality, a substantial slippage compared to the revised target of 4.7 of GDP cannot be ruled out. Both these developments would have implications for variables that concern monetary policy such as inflation expectations, liquidity pressures, and private investment. In terms of solutions, the economy needs deep and decisive fiscal and energy sector reforms and an early realization of planned foreign financial inflows to mitigate uncertainty. Another area of reform is to improve financial deepening and competition in the banking system. In this vein, SBP has already been encouraging depositors to put their savings in government securities through Investors Portfolio Securities (IPS) accounts. Among other objectives, this is expected to lead to better returns on deposits over time. Moreover, in May 2008, SBP introduced a minimum 5 percent floor on all categories of Savings/PLS Saving Products. Consequently, average deposit rate of all saving related products increased from 2.1 percent to 5.25 percent, with no significant change thereafter. The saving deposits category now account for 38 percent of all bank deposits and 52 percent of total number of deposit accounts. It was the expectation of SBP that these deposits will respond to market forces and adjust accordingly. The rigidity of the deposit rates, especially for small savers, is adversely impacting the savings-investment ratio of the economy. A more balanced risk-reward incentive structure is warranted in the shape of appropriate deposit rate structure, as the savers, especially the smaller ones, need to be adequately compensated. Therefore, it has been decided that, effective 1st May 2012, all Banks are required to pay a minimum Profit Rate of 6.0 percent on PKR Saving/PLS Saving Products. At the same time, given the overall macroeconomic conditions, the Central Board of Directors has decided to keep the policy rate unchanged at 12 percent. While managing the external and fiscal pressures remain more of an immediate concern, the real challenge lies in reviving private investment in the economy. Inflationary pressures have not subsided either despite sluggish GDP growth. At the same time, the scheduled banks continue to avoid extending credit to private businesses, which are already suffering from energy shortages. Fiscal authority, on the other hand, is accumulating short term domestic debt at a rapid pace. The impact of SBPs monetary policy, in these circumstances, is less effective. The economy basically needs fundamental reforms to engineer a turnaround in economic performance. For instance, inflation

expectations cannot be effectively anchored around single digit targets without limiting fiscal borrowings from the banking system, particularly the SBP. Borrowing from the banking system has risen substantially during this fiscal year, Rs 1098 billion (Rs707 billion excluding the Rs391 billion related to the partial settlement of circular debt), from 1st July to 25th May, FY12 with borrowing from SBP (on cash basis) expanding by Rs 414 billion during the same period. In fact, the latter has accelerated during 1st April to 4th June, 2012, increasing by Rs310 billion, pushing the outstanding stock to Rs1660 billion (on cash basis). This behaviour contravenes the SBP (Amendment) Act 2012, which requires not only zero quarterly borrowings but also envisages their retirement in the next seven years. Not surprisingly, the year-on-year CPI inflation has increased to 12.3 percent in May 2012. A noteworthy aspect of inflation behaviour is its persistence at this high level alongside slack economic activity. A probable explanation of this persistence is that the expansionary effect of the fiscal position is offsetting the weak private demand, especially investment demand. SBP is not expecting a sharp increase in inflation but its continuation around current levels in FY13. The issue is not just aggregate demand pressures but also peoples expectations. Therefore, limiting and retiring budgetary borrowings from the banking system and implementation of consistent and credible policies would help in moving away from this undesirable equilibrium. The sheer volume of borrowing from the banking system and expectations that this trend will continue, in the absence of fiscal reforms, has made banks complacent. They are simply channelling the economys incremental deposits, raised at 7 percent on average, to government securities that give an average return of approximately 12 percent across different maturities. Specifically, the scheduled banks perceive the government as a captive borrower and can afford to avoid the private sector without taking a hit on their profits. The real issue is the structural gap between fiscal revenues and expenditures of the fiscal authority. This gap cannot be narrowed without fiscal reforms. In particular, it would be difficult to reduce the scale of borrowings from the scheduled banks and adhere to the legal requirements of limiting and retiring borrowings from the SBP without generating additional revenues. Falling private investment to GDP ratio to 12.5 percent in FY12 according to provisional data, also echos the need for fiscal reforms. Absence of an enabling business environment due to persistent energy shortages and precarious law and order conditions has dampened the demand for fresh private credit. Therefore, urgent energy sector reforms are required to boost business confidence and arrest the declining investment to GDP ratio. As for the developments in the external sector, the issue is not the size of the external current account deficit but lack of sufficient external inflows to finance it. Cushioned by robust worker remittances of $10.9 billion, the current account deficit was $3.4 billion during the first ten months of FY12. After incorporating the estimated deficit for the remaining two months, it is likely to remain around 1.7 percent of GDP for FY12, which is not large for a developing country like Pakistan. The net flows in the capital and financial account, on the other hand, were only $1.4 billion during the same period. Accounting for repayments of the IMF loans during the year, SBPs net liquid foreign exchange reserves have declined to $11.3 billion by end-May 2012 compared to $14.8 billion at end-June 2011. For FY13, the size of the external current account deficit as percent of GDP is projected to be approximately the same as in FY12. However, due to anticipated rise in debt payments in FY13, the economy would need substantial external inflows to preserve our foreign exchange reserves. Further, the problems in the euro zone have increased uncertainty in the global economy. Being a safe haven for investors, the US dollar has strengthened significantly in the past few weeks against almost all currencies, especially the euro, and Pakistan rupee was no exception. Appreciation of the US dollar in international markets is probably one explanation why oil prices have eased somewhat, declining from a peak of $130 per barrel (Saudi Arabian Light) on 3rd April 2012 to $97 per barrel on 1st June 2012. This, together with expected global slowdown may keep the oil prices softer compared to earlier projections. Given that almost one third of Pakistans total import bill is due to oil payments, this would be a positive development. For instance, with the current quantum of petroleum products and crude imports at 21 million metric ton, a decline of $5 per barrel in international oil prices could save up

to $700 million in import payments in FY13. After an assessment of the macroeconomic challenges faced by our economy, the Central Board of Directors of SBP has decided to keep its policy rate at 12 percent.

FISCAL POLICY Pakistans fiscal profligacy has been in the news for the last five years. All those who have an interest in Pakistans economy have been writing on this issue and highlighting the importance of fiscal discipline in preventing macroeconomic imbalances as well as achieving a full growth potential. The government, on the other hand, appears to be least interested in pursuing a sound and disciplined fiscal policy. Hence, the rot continues in terms of low economic growth, stagnating job creation, increased poverty, higher inflation and more debt. Every government typically aims at promoting strong and sustainable economic growth with a view to creating employment opportunities and lasting poverty reduction. This must probably be achieved by pursing a sound and disciplined fiscal policy. This fact may not be known to the political leadership, but it is assumed that the economic team of every government knows the importance of fiscal discipline for the economy. If the economic team members do their job honestly and urge their political leadership to pursue a disciplined fiscal policy, things would move differently. A rule-based fiscal policy has generally been associated with improved fiscal performance and debt sustainability. Over the past several decades, there has been increasing acceptance worldwide that fiscal discipline over a prolonged period is essential for maintaining macroeconomic stability. There also exists a general consensus that a prolonged commitment to fiscal discipline can only come from a rule-based fiscal policy. Fiscal rules basically represent constraints, and prevent the government from taking a fiscally irresponsible route. International experience suggests that countries, which have adopted well-designed fiscal rules and implemented them effectively, have garnered important credibility gains, greater electoral support, and achieved higher economic growth on a sustained basis. Fiscal rules aim to prevent governments from taking short-sighted measures in the light of election cycles and competing demands from special interest groups, by binding policymakers to a fiscally prudent path. Pakistan has experienced serious macroeconomic imbalances in the 1990s mainly on account of its fiscal profligacy (budget deficit as percentage of the GDP has averaged almost 7.0 percent per annum), and has accordingly paid a heavy price in terms of slower economic growth, rising debt burden, and the rise in poverty. It is against this backdrop that work on a rule-based fiscal policy was initiated in 2001-02. After one year of hard work and wide-ranging consultation in all the four provinces, a rule-based fiscal framework was prepared in 200203. This framework was enshrined in the Fiscal Responsibility and Debt Limitation (FRDL) Act 2005, and was passed by parliament in June 2005. The purpose of the Act was to inject fiscal discipline in the country. This Act ensures responsible and accountable fiscal management by all governments, the present and the future, and would encourage informed public debate about fiscal policy. It requires the government to be transparent about its short and long-term fiscal intentions and imposes high standards of fiscal disclosure. There are five key elements of the law. Firstly, beginning from July 2003 (2003-04), Pakistans public debt would not be more than 60 percent of the GDP by end June 2013 (2012-13). In other words, Pakistans public debt had to be reduced from 75 percent to 60 percent of the GDP in ten years. Secondly, every year the government would reduce public debt by at least 2.5 percentage points of the GDP during the ten year period. Thirdly, revenue deficit (total revenue minus total current expenditure) would be eliminated by 2007-08 and a surplus would be maintained thereafter. Fourthly, the government would not provide guarantee to the borrowings of the Public Sector Enterprises (PSEs) by more than two percentage points of the GDP in a given year. Fifthly, social sector and poverty-related expenditures would not be less than 4.5 percent of the GDP for any given year, and the expenditure on education and health would be doubled in terms of percentage of the GDP in ten years. As can be seen from the above, the law binds the government to pursue a sound and disciplined fiscal policy. It binds the government to reduce public debt to a sustainable level, reduce the countrys debt burden every year,

mobilise resources at least to the extent of its current expenditure, prevent the government to cut social sector and poverty-related expenditures and double education and health budgets. It also forces the government not to provide guarantee to the borrowings of the rotten PSEs to prevent the growth of contingent liabilities. A high-level debt policy coordination office was established in the ministry of finance. Besides many other functions, the debt office was made the secretariat to monitor the performance of the law. Every year, before January 31, the debt office prepares two reports the fiscal policy statement and debt policy statement and submits them to parliament under Section 6 and 7 of the Act, respectively. While analysing the developments on the fiscal and debt front in a year, the reports also give a compliance report of the Act. Some 500 copies of each report are submitted to the National Assembly and Senate Secretariat for distribution to the members. From 2003-04 to 2006-07, the law performed very well. Public debt declined from 75 percent to 55 percent of the GDP during the period. However, most of the critical elements of the law have been violated in the last four years. In particular, public debt, instead of declining, has increased to 60 percent of the GDP and revenue deficit continues to prevail. None of the members of parliament has ever raised the issue of violation in the House; hence, no debate has taken place in parliament. Nobody bothers and nobody cares about the law and hence, Pakistans economy continues to create pain and misery for the hapless millions.