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Old Friday, June 08, 2007
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SBP Report on the state of the economy

EDITORIAL (June 08 2007): The State Bank of Pakistan's Third Quarterly Report for FY07 has been issued. As it should have been, besides stating plain facts about the economy, it focuses on the strong and weak areas of the national scene close to the end of the financial year and hence becomes important as the basis for the forthcoming budget to be framed in the light of the macro-economic objectives of the FY07 scheme and the objectives it would aim to achieve in FY08, as the country moves forward from the successes and failures of the outgoing year.

The year FY08 being the election year, the co-runner FY07 has also taken the toll what with the steps to create an economic ambience that favours the Government electioneering campaign.

But the most important question that needs to be answered is: how to justify the widening gap between the kitty and the burgeoning expenditure which would be incurred to appease the electorate who do not understand what the gap between the two means to them in terms of their purchasing power that stands eroded enormously?

Going by the picture presented in the SBP Report, the real GDP growth is expected to exceed even the projected 7.0 percent for the year, besides being broad based. FY07 would thus become the fourth year in succession to have seen high economic growth that should be quite satisfying as an election slogan. But a painful trade-off had to be accepted: the process of accelerating growth totally marred the prospect of achieving the coveted objective of decelerating inflation to 6.5 percent by the end of the year. At least this is what the SBP Report confirms beyond questioning.

According to the SBP, its tight monetary policy helped maintain a rather complex balance between decelerating inflation and maintaining growth momentum by "removing excessive monetary stimulus from the economy," leaving aside the food inflation which increased incessantly in the later part of the year. Notwithstanding the growth momentum at the cost of so much monetary pains, the supply-side pressures persisted only to be reflected in the rise in the prices of a number of edibles.

The Report says: "Unfortunately the impact in reducing inflationary pressures has been offset partially by the rise in food inflation and supply side pressures." The Bank did not substantiate the actual impact of food inflation on the CPI in terms of its weight in the Index. Revising SBP's earlier forecast on inflation, the Report observes:

"As a result of the unexpected resilience of food inflation and likely pressures in near term due to increases in the prices of milk and edible oil etc, SBP forecast for FY07 has been revised upwards from 6.7-7.5 percent to 7.5-7.8 percent."

Supply side pressures could be explained by rising consumption of petrol and petroleum products in the wake of increasing numbers of vehicles on the roads, despite the fact that a large number of them shifted to using domestically produced natural gas.

The record receipt of dollars from expatriates converted into rupee which is weakening unit by unit must have added to the rise in prices of many food items and electric and non-electric durables as high inflow of remittances has historically turned our increasing population ever more consumption oriented.

The Report, therefore, does not foresee any immediate relief to the people, particularly the poor, from their number one enemy, inflation, in the near future. We, however, cannot help reminding the central bank, which now enjoys quite a measure of autonomy, that with grit and determination it can always fight the war against inflation, together with the government, and become a trust worthy friend of the people.

The State Bank pursued a tight monetary policy for the very purpose of fighting inflation. One could ask a very pertinent question here: did the tight monetary stance of the central bank really work or did not because enough support was not available from the other end? Perhaps not, would be the right answer!

The other end connotes two important players, the Finance Division and the CBR. At the Finance Division end, the Public Sector Development Expenditure continued inflating, with excuses like justification of growth momentum, which cannot be attained under the obtaining power crisis, awfully neglected infrastructure and lack of social sector facilities. If these odds were removed, it could lead to creation of additional employment and hence moderation of existing poverty levels.

At the CBR end, loopholes in the country's taxation system took their toll and what could have been available for financing part of the increasing PSDP went into fuelling inflation. The question arises: When shall we tax the windfall money earned by the real estate and stock market sectors which also entail a damaging effect on the ruling land prices?

When shall we tax the big landlord who owns the lion's share of the country's land wealth and also enjoys the vetoing power in the legislature? Look at their large numbers in the Parliament with the increasing number of industrialists and businessmen turning landlords?

When shall we rationalise imposition of sales tax to bring larger numbers of individual traders and the services sector in the tax net? Who will bell the cat to tax the huge gains earned in stock trading where share capitalisation is setting new records? Their untaxed earnings are only adding to the inflationary pressures in the economy, worsening the already wretched living conditions of the poor of the country.

In our view, the apparently tight monetary policy in one way or the other yielded to the accommodative stance emanating from the government side. The result was that by May 12, the growth in broad money clearly surpassed the growth recorded last year by nearly 2 percent points or Rs 120 billion. Growth in reserve money or RM which proliferates (or contains) money balances was like-wise burgeoning.

The growth in RM recorded during FY07 up to May 12 worked out to over 20.12 percent compared with 14.65 percent recorded in the corresponding period of FY06. Concessional credit provided by the central bank to a number of export oriented sectors and target beating government budgetary borrowings from the banking system (Rs 212 billion as on May 12 compared with the target of Rs 120 billion) can be regarded as the contributing factors to the growth in both RM and M2.

Thanks to lower than targeted growth in credit to the private sector, which helped moderate the otherwise strong inflationary pressures, by May 19, private sector credit was at its highest of Rs 264 billion up 12.5 percent over 30th June 2006 compared with the target of Rs 390 billion.

THE STATE BANK NEEDS TO EXPLAIN: Was it really the tight monetary policy or some other factors that contributed to this even lower than projected growth of credit in the private sector? Even here, the growth, according to the Report, was concentrated in a few business sectors. What non-bank sources financed the rest of the sectors if growth in GDP was expected to surpass the projected 7 percent?

We presume that the real test of SBP's tight monetary policy, which is to continue in FY08 as Governor Akhtar recently indicated, would be in FY08 when, according to the SBP Report, "high reserve money growth in FY07, together with the rising demand for private sector credit, raises the risk of a strong resurgence in excess aggregate demand, and consequently inflationary pressures in FY08".

We reiterate that for the present the SBP has recognised, in guarded phrases though, that the tight monetary did not work to the extent desired on two counts. Commenting on developments in money and banking, the Report admits fairly honestly that the "key challenge for SBP monetary policy during FY07 has been to maintain a balance between sustaining strong economic growth and low and stable inflation" the latter by and large being predicated on the size of money balances in the economy.

At another place the confession reads: "The challenge to the modulation of monetary policy is increased by the recent acceleration in the growth of monetary aggregates" which was due to excessive budgetary borrowings. The Report stresses that with likely "strong resurgence in excess aggregate demand, and consequently inflationary pressures in FY08" it appeared imperative that the "fiscal policy be aligned with monetary policy in months ahead". We add not only in the months ahead but throughout FY08.

After all, why a Monetary and Fiscal Policies Coordination Board was created by amending the SBP Act if it was doomed to failures in achieving the desired coordination between the two policies? It indeed infringes the autonomy of the central bank, besides creating the impression that the two policies had in fact been moving in opposite directions, which reflected the inability of policy makers to co-ordinate prudently as opposed to imprudently.

The Report has described the government's borrowings as a rather "worrying dependence" especially when fiscal deficit has been capped to stay at 4.2 percent of GDP by the end of current fiscal year. We had already explained why the burgeoning deficit became a worrisome dependence, but calculating the cap ratio to the GDP at the end of the year runs the additional risk of playing with the figures by the interested quarters.

This takes us to developments in another important area, namely, the trade and current account status. To recall, throughout the year we have talked of widening trade gap despite compression in imports clearly indicating less than satisfactory growth of exports. The country is about to achieve a 7 percent growth rate.

Where has gone the export potential created by the phenomenal growth: across the borders and at whose cost has it been thrown away by the export guardians in the Ministry of Commerce and its allied institutions? Yes, the current account deficit "has decelerated sharply as FY07 progressed".

The SBP Report, however, goes on to add: "While this (current account deficit) was comfortably financed by even larger surpluses in the financial and capital account (with substantial non-debt components), the country's success in attracting international capital has led to a large jump in the NFA of the banking system adding to liquidity in the domestic market."

May be, this jump became available to the private sector to meet its credit requirements without resorting to bank credit, but certainly created excess demand for availabilities.

International capital that flowed in the country consisted of US financial assistance, proceeds of privatisation, borrowed money from international financial market using floatation of sovereign bonds and initiating GDR listings. These resources are welcome for any emerging economy like ours but their vulnerability to political mishaps cannot be ruled out which makes them unreliable as a long term financing source.

Ground realities of the economy are, however, hard for the common man to digest despite the hopes hinged on record increase in Foreign Direct Investment, unparalleled increase in the market capitalisation of shares attracting dollars and rupees alike, relatively stable dollar-rupee parity losing only about a rupee against the dollar, high GDP growth, comfortable foreign flows, especially expatriate remittances, and inflating foreign exchange reserves ready to cross the $14 billion mark.

High inflation remains the major discomforting factor and appears to be the result of unfettered profiteering and hoarding by market manipulators, on which the government has moved rather sluggishly to take any effective steps. The market can indeed go its way but the governments are bound to take prudent measures to correct the situation.

To conclude, the SBP Report sees that real GDP growth would comfortably reach the target of 7.0 percent in FY07 or may even exceed it. However, domestic inflation is forecast to remain in a relatively higher range than expected earlier.

The report emphasises the importance of appropriate monetary policy to achieve price stability as sustained high inflation has particularly adverse consequences for low-income groups who have no means to hedge themselves against this evil. The report underscores that concessional re-finance to strategically important sectors of the economy will have knock-on impacts by raising monetary growth in subsequent periods through increase in reserve money occasioned by such credit.

The impact on reserve money growth has also been compounded by the heavy reliance on central bank for borrowings by the government and the growth in NFA of the banking system. Referring to higher than projected current account deficit, the Report finds a source of comfort in that the monthly growth in the current account deficit continues to decelerate, and that given strong international liquidity flows towards emerging markets including Pakistan, the current account deficit is likely to be comfortably financed in the short-run.

However, the Report warns that international capital flows could be volatile, hence problematic. The long run health of the economy, therefore, requires a lower sustainable current account deficit, concurrent with a rise in the domestic savings rate and a gradual reduction in the fiscal deficit through increase in the tax-to-GDP ratio.
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