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Monetary policy in fiscal stress

Intersection of monetary policy and financial imbalances merits debate and further research in Pakistan

Monetary policy in fiscal stress
The declining value of currency was termed necessary for boosting exports.

Monetary policy decisions of the State Bank of Pakistan (SBP) in the recent past seem exclusively guided by traditional “separation principle” wherein monetary policy is limited to price stability, inflation control exclusively. Limited financial space, lower stability of finances and other related issues are left for treasury. Countries facing higher financial stress with future stream of limited fiscal space, as is the case for Pakistan now, demand a different conduct of monetary policy.

That Pakistan is going through fiscal stress and is likely to continue to do so for several years is a consensus now. The budget deficit reached 6.6pc in fiscal year 2017-18 as expenditure grew by an average of 13.7pc per annum, outpacing revenue growth at 8.5pc. The trend seemed to be continuing.

Tax collection for the first six months (July-Feb) of FY 2018-19, recorded a shortfall of Rs233.2 billion against the target set for the aforementioned period. The shortfall at the end of FY2018-19 may reach Rs486 billion. Experts believe that budget deficit may reach 7pc in FY 2018-19. Fiscal space is likely to shrink to the maximum level. Trade deficit, though shrinking as economy slows down, will remain a challenge.

This piece argues that the present monetary policy framework in Pakistan does not give enough consideration to the build-up of fiscal imbalances. Ignoring fiscal space limitations and financial stress, recent monetary policy in Pakistan seems exclusively focusing on price-stability. The 100 base point interest rate hike in July 2018, another 100 base point in August 2018 and yet as higher as 150 base point raise in Nov 2018, completely focused on curbing inflation, ignored fiscal implications including but not limited to higher domestic debt servicing costs.

The rate hike decisions seem to have been over reaction to oil price rise and depreciation of rupee. To some extent, though implicitly, rate hike seems meant to discourage government’s ever-increasing borrowing from the Central Bank. Marginal hike of 25 base points in January 2019, experts believe, was a face-saving as otherwise it would indicate poor decision-making in the last three hikes.

The policy rate hike from 6.5 to 10.25 since July 2018 absolutely ignores the implications for financial stability. The massive hike in the tariff and energy prices had already not only increased the cost of production, but ended up in making local products uncompetitive. Interest rate hike contributed to the costs further. It may or may not control the inflation, but certainly inflates the budget deficits.

That Pakistan is going through fiscal stress and is likely to continue to do so for several years is a consensus now. The budget deficit reached 6.6pc in fiscal year 2017-18 as expenditure grew by an average of 13.7pc per annum, outpacing revenue growth at 8.5pc.

Monetary policy through changes in interest rate not only limits government’s demand for borrowing from the Central Bank but also affects capacity to repay local currency debts. Higher interest rate may lower the demand for government borrowing from central bank but also increase the budget deficits further as cost of domestic debt servicing increases.

In this context, the effects of monetary policy extend to financial sustainability-objective of fiscal policy. This brings monetary-fiscal policy coordination at the center stage. Monetary policy in Pakistan seems missing this dissensions.

In financial year 2018, rising interest rates on domestic debt servicing remain the largest head by share in expenditures, 28 percent. Three factors may inflate this share in FY 2019. First, interest rate witnessed an increase of 375 bases points since July 2018. Second, borrowing from SBP stands more than doubled, increasing from Rs3.667 trillion in July 2018 to Rs7.647 trillion in December 2019. Combined these two will result in huge domestic debt-servicing cost.

Adding to the worry is that the government is failing to meet revenue targets. The government has no option but to borrow more, and that at higher cost. Now combined all this, the government may end up in fiscal stress spiral. This may further push the government to extract revenues from hike in prices of petrol, gas and other energy products. This is inflationary by very definition. This may limit inflation control impact of higher policy rate which is already showing up as inflation in February 2019 reaches 8.1pc.

Pakistan’s public debt is on the rise. Pakistan’s total debt and liabilities increased to Rs29.8tr by the end of June, which is 86.8pc of GDP. It is well above the so-called debt sustainability limit of 60pc of GDP. Most important, in context of monetary policy is the composition of public debt. Recording about 74pc growth in last five years, Pakistan’s domestic debt rose to Rs16.4tr sharing approximately 55pc of total debt and liabilities.

Higher interest rate means taxpayers paying higher amounts to service local currency debt. Already, the estimated interest payment and loan repayment on both foreign and domestic debt will consume 39pc of the total revenue in 2018-19. And this has medium and long term implications. Most importantly, it will slow down the growth.

Mainly sponsored by rising oil prices, the inflation is expected to rise further backed by interest rate hike. Matching it, deflationary monetary policy will continue ballooning domestic debt service. Slowing growth, lower revenue collection coupled with higher share allocated to local currency debt repayments can inflate fiscal deficit further.

Monetary policy of Pakistan needs to update on at least three fronts. First, it needs to add financial/fiscal stability in its policy rate decisions making. Had it been done recently, it would have at least slowed down the pace of rate hike without changing its strategic direction. Second, monetary policy needs to reconsider magnitude of response to exchange rate stress. Presently, it seems over reacting. Third, while no one is asking monetary policy to focus to solving fiscal problems, the policy choices should be considerate of the fiscal implications of monetary decisions.

Extreme reliance on separation principle in time of financial stress, like the one Pakistan is going through, may create unnecessary fiscal uncertainties “which can undermine the ability of monetary policy to control inflation and influence real economic activity in the usual ways” as conclude experts. In this context, intersection of monetary policy and financial imbalances merits debate and further research in Pakistan.

Dr Sajid Amin Javed

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