The irrelevance of monetary policy By Dr Javed Akbar Ansari

THE State Bank’s Monetary Policy Statement for April to June 2010 is an eye-opener. Quarterly monetary policy statements have always been lengthy and substantial documents. The statement of January 2010 was of over 20,000 words with a detailed analysis of the impact of monetary policy on the macro-economy and justification for its initiatives.

However, the Monetary Policy Statement (MPS) issued on March 27 contains less than 1000 words and less than 100 having anything to do with the monetary policy.

Indeed the “monetary policy statement” for April – June 2010 has been crammed into one sentence: “An upward adjustment in SBP’s policy rate at this juncture runs the risk of impending recovery while a downward adjustment runs the risk of fuelling an already high inflation. Hence the SBP has decided to keep the policy rate unchanged”.

No justification is offered for the dogma that a reduction in the ‘policy rate’ will enhance inflationary pressure. There is overwhelming evidence that this is not true and the near-zero interest rates in Japan, Europe and America in recent years have generated no inflationary pressure at all.

The 40-word “monetary statement” shows that the State Bank cannot offer any justification for its monetary management. It has lost control over money supply ––especially changes in the NFA. It is quite incapable of reducing inflationary pressure. The year-on-year increase in CPI inflation has risen from 8.9 in October 2009 to 13.1 per cent in February 2010. Food inflation has doubled during this period – from 7.5 in October 2009 (year- on- year) to 15 per cent in February 2010.

Even the most massaged “20 per cent trimmed core mean” inflation increased on year-on year-basis from 10.6 in October 2009 to 12.4 per cent in February 2010. Wholesale price inflation has increased spectacularly from 3.8 (year-on-year) in October 2009 to 19.3 per cent in February 2010 and wholesale food inflation tripled during this period. Non-food wholesale inflation rose from 2.2 (year-on-year) in October 2009 to 22.6 per cent in February 2010.

The State Bank policy interest rate is currently 150 per cent higher than the policy rate in India, 500 per cent higher than that of Malaysia and 135 per cent higher than that of China. The current policy rate in America is 0.25 per cent, in Japan 0.1 per cent and the EU region one per cent

The State Bank has cut back its financing of the fiscal deficit by Rs64 billion due to the IMF pressure but it has been unable to prevent a massive growth of commercial and NBFC public deficit financing which has amounted to almost Rs300 billion in the first half of this fiscal year. Commercial bank financing of the fiscal deficit during the first half of FY10 exceeded budgeted estimates for the whole year by 76 per cent.

The State Bank has been unable to check the growth of domestic debt. The stock of public debt held by commercial banks at end January 2010 was 23 per cent higher than that at end June 2009. The stock of non- bank government debt grew by 12 per cent during this period. Total domestic debt rose by over 40 per cent during the first half of FY10.

Most of this is short-term (i.e. floating) debt. Debt service payments on permanent debt in the first half of FY10 were 60 per cent higher than in the first half of FY09. The SBP’s “Information Compendium” provides no comparison of external debt servicing in the first quarters of FY09 and FY10 but service payments on foreign exchange liabilities in the first quarter of FY10 exceeded the total liabilities servicing of FY09 by 61 per cent.

The interest payments to the IMF in the first quarter of FY10 exceeded total interest payments to the IMF during FY09 by 15 per cent. The external debt servicing to export earnings ratio will probably exceed 30 per cent at end FY10 and may be higher than in any year since FY05.

The State Bank has no control over the inexorable build-up of foreign debt and liabilities and its associated service costs. It has no control over the services and income accounts of the balance of payments (During July to February 2010 payments on the income accounts exceeded receipts by 376 per cent). This shows that the SBP has emasculated itself and is now nothing more than a colonial currency board.

The SBP’s control over net domestic assets (NDA) is also weak. It no longer mentions monetary aggregate targets set for FY2010 but the IMF expected SBP’s net domestic assets to decline from Rs1412 billion at end -March 2009 to Rs1314 billion at end-June 2010, a fall of Rs98 billion.

During end-June 2009 to March 13, 2010, NDA of the banking system as a whole increased by Rs275 billion and government borrowing rose by Rs259 billion. It is hard to believe that SBP’s NDA contracted during the first half of FY2010 according to the IMF’s targets. Year-on-year M2 growth at end February 2010 was as high as 19.2 per cent which is significantly higher than the IMF’s implicit targets and probably higher than nominal GDP growth during the period.

However up to end February 2010 private credit grew by only 1.3 per cent in nominal terms which amounts to a huge reduction in real terms if we take account of the officially estimated near 14 per cent rate of inflation. The private sector credit to GDP ratio has declined from 30 in March 2009 to 28 per cent in March 2010.

The SBP continues to operate a tight monetary policy despite clear evidence that this policy strangulates investment growth and thus fuels inflation. The SLR on demand deposits has been raised from 18 in July 2009 to 19 per cent in March 2010. Money market trends continue to depict tight liquidity positions. Term-wise KIBOR and term-wise REPO and PIB secondary market rates rose during the third quarter of FY10, the yield curve steepened and the spread between six month KIBOR and six month repo rate widened significantly. The weighted average loan rate increased in the third quarter of 2010 and the spread with respect to the weighted average deposit rates remained almost unchanged at about 650 basis points. The ineffectiveness of the SBP’s monetary policy is evident from the dismal picture it painted. In its “Monetary Policy Decision” of March 27, 2010, the State Bank shifts the blame for the growth of inflationary pressure on to the federal ministry of finance. It laments “fiscal sector uncertainty”. It blames the government for fueling inflation by increasing administered prices (of electricity, petroleum products and wheat) and asserts that public investment and expenditure is “crowding out” private investment although detailed empirical work at PIDE and CBM has demonstrated the falsity of this dogma.

The SBP toes the IMF line and applauds the government’s “phasing out of subsides and reduction in development expenditure”.

There is no doubt that the overall macroeconomic strategy espoused by the People’s Party government has collapsed. This strategy does not seek to redress the fundamental structural weaknesses of the national economy and places exclusive reliance on obtaining foreign public loans and grants to deal with balance of payments difficulties. But those who continue to subject Pakistan to drone attacks and use our forces to fight America’s war of terror do not pay up.

The SBP laments, “external financing, specially the part pledged by the Friends of Democratic Pakistan has been elusive”. Ninety per cent of foreign financing obtained so far has come from the IMF and is of an emergency, short run nature. The refusal of these fickle ‘friends’ to put their money where their drones are, has led to a major fall in both foreign direct investment and workers remittances

Neither the State Bank nor Zardari’s government has the capability to change the course, abandon the market-based monetary policy and adopt a domestic demand-oriented macroeconomic strategy.

Source: http://www.dawn.com/wps/wcm/connect/dawn-content-library/dawn/in-paper-magazine/economic-and-business/the-irrelevance-of-monetary-policy-240