On June 8 the State Bank of Pakistan (SBP) issued a brief statement on the country’s economic situation, while announcing no change in its policy rate for the next two months. It was accompanied by an information compendium that contains the latest data on various aspects of the economy. The information provided by the SBP is more transparent than that released by the ministry of finance at the time of the introduction of the budget for FY13. Moreover, unlike the government, it made no attempt to cover up the facts or to twist the analysis, except when it came to the foreign sector.
The SBP states that the effectiveness of its monetary policy is being hampered by fiscal mismanagement. It even concedes its helplessness in ensuring enforcement of the provisions of the law relating to government borrowing from the banking system. Notwithstanding the passage of a new legislation a few months ago by the parliament to restrict government borrowing from the SBP, there is an implicit apprehension there that the government may continue to borrow additional amounts on a regular basis, rather than start reducing its outstanding debt as provided in the legislation. If this apprehension materialises, there will be serious economic and legal implications.
First, it will confirm that the government has no respect for the laws that it itself passes and, in the absence of adherence to the rule of law by the government itself, it cannot be expected to establish the rule of law in the rest of the society.
Second, the government’s credibility cannot be judged by what legislation it passes but by the extent to which it adheres to the laws. On that score, the government has a very poor track record and it suffers from a credibility deficit.
Third, statutory SBP autonomy would not mean much in effect until and unless ways are found to make the government adhere to the laws. In case the SBP is not allowed to function professionally and autonomously within the legal framework created by the government itself, as is the situation now, the state of the economy will not only remain poor but will continue to deteriorate. The government needs to change its mindset and begin to respect the SBP as an autonomous central bank of the country rather than continue to treat it as a subordinate department of the ministry of finance. There is worldwide recognition that an independent central bank is imperative for sound economic management and good governance.
The SBP statement and the accompanying statistical compendium make it very clear that the financial and economic situation is grim. There is a wide structural imbalance between government expenditure and its revenue, which is currently being dealt with through reliance on domestic short-term bank borrowing. The SBP has not been able or willing to exercise its legal power to “determine and enforce” the limit on government bank borrowing. It is leading to excessive creation of the net domestic assets of the banking system that, by their very nature, are inflationary in their impact. For example, the net domestic assets of the banking system increased by 16 percent up to May 25, this year as compared to 9 percent in the corresponding period last year.
If fiscal reforms are not implemented to narrow the budget gap, and the SBP remains helpless in enforcing the legal provisions of the SBP Act, there is no way that in an election year the government will voluntarily adhere to the legal requirements of “limiting and retiring” borrowings from the SBP. The most it will do is to instruct the SBP to provide liquidity to banks and divert government borrowing from the SBP to that from commercial banks. But the implications of such an arrangement will be the same as that of direct borrowing from the SBP.
With continued excessive government borrowing, inflation will be in double digit and the government target of reducing it to 9.5 per cent in FY13 will remain a pipe dream. The wide “inflationary gap” between growths in the availability of real goods and services and in money supply due to excessive government bank borrowing will continue to fuel inflation and keep inflationary expectations alive to give further boost to inflation.
The increased reliance of the government on borrowing from the banking system at high interest rates with no default risks would continue to incentivise the commercial banks to lend to the government rather than to the private sector and thereby inhibit the revival of private investment and economic growth. Moreover, the complacency of the banks in mobilisation of additional deposits and provision of credit for productive private sector economic activities will discourage financial intermediation because the banks can maintain their profitability by lending to the government through borrowing from the SBP.
The SBP also points to the need for creation of an enabling environment for promotion of saving and investment to accelerate the rate of economic growth on a sustained basis. The budgetary and energy sector reforms and improvement in the law-and-order situation are essential prerequisites to boosting business confidence and arrest declining saving/GDP and investment/GDP ratios.
In describing the balance of payment situation, the SBP becomes cagier. In the aftermath of the interview to The Wall Street Journal of the governor of the SBP on the anticipated precarious foreign-exchange position, and the strong reaction to it of the market and the government, the SBP analysis of the external sector is much less forthcoming and in certain ways misleading.
The SBP twists the analysis of the balance of payments by stating that the rising current account deficit is not a problem and that the real problem is lack of sufficient external inflows to finance it. It makes no mention of the widening trade deficit reflecting a rising level of imports and declining exports.
As private direct investment is unlikely to materialise in the present political, security and economic situation, what the SBP is suggesting is more net borrowing from abroad to cover the current account deficit. But that is precisely the approach that has led to the high level of external debt whose servicing is becoming increasingly difficult in the face of inadequate growth in exports. What is needed is not more borrowing from abroad to finance the widening current account deficit but policy measures to restrain imports and accelerate exports in order to reduce the deficit in the trade account.
The foreign debt situation is already very precarious as confirmed by the SBP in its information compendium. While foreign debt as a percentage of GDP in the last four years has remained in the range of 28-33 percent of GDP, due mainly to the impact of high inflation on the nominal GDP, foreign debt has gone up sharply as a percentage of reserves as well of exports. Similarly, foreign debt servicing consumes a large part of government revenue and exports. Debt servicing as a percentage of exports has gone up from 17 percent in FY07 to 35 per cent in FY11.If domestic debt is also included, the situation looks even more precarious. In FY11, debt servicing was more than 50 percent of the total current expenditure of the government and it consumed 78 percent of the tax revenue and 59 per cent of the total revenue. All this indicates that focus should be on increasing exports and tax revenue and reducing imports rather than on borrowing more from abroad or domestically.
The SBP mentions a loss of $3.5 billion in its foreign exchange reserves in the last 11 months. If this trend continues, the depleting reserve level will lead to panic buying of foreign exchange and put further pressure on the exchange rate. With a large debt repayment due in FY13 and a wide current account deficit, the SBP fails to recognise that reserves are likely to go down sharply necessitating either a new standby arrangement with the IMF or leading to a potential debt default. Either of the two will have serious implications for economic management, and add to the economic hardship of the people.
The SBP caution in analysing the balance of payments perhaps reflects more its concern about market and government reaction and less a premeditated attempt to conceal the truth.
The writer is a former governor of the State Bank of Pakistan.