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January 27, 2015



Pretentions of autonomy

The writer is a former governor of the State Bank of Pakistan.
On January 24, the State Bank of Pakistan announced that it had decided to reduce the policy rate by 100 basis points to 8.5 percent effective from January 26. This is a ritual through which the SBP goes every alternative month, designating it as its monetary policy.
While releasing the monetary policy statement, the SBP governor held a press conference in which he defended the government’s economic policies in whose formulation the SBP seemed to have made no professional contribution. More strikingly, even when the finance minister had already announced the reduction in the policy rate, the SBP governor declared with a straight face that “the decision was taken during a meeting of the Central Board of Directors of the SBP under his chairmanship”. It is obvious that even if the decision was rubberstamped by the SBP Board, it was dictated by the Ministry of Finance. The whole episode made a mockery of the respectable office of the governor and the hard-earned statutory autonomy of the SBP acquired through legislative reforms.
The monetary policy statement gives the impression that the economy is in a robust state, and about to take-off to new heights. A correct interpretation of the data given there and available elsewhere would give the opposite message. However, instead of wasting our time in commenting on what is and is not right in the statement, an attempt is being made below to explain the issue of efficacy of the policy rate as an instrument of monetary policy. Even if the governor already knows what is stated below he may wish to go over it any way to refresh his memory.
The three main instruments of monetary policy are reserve requirements, open market operations and discount/policy rate. The first two are quantitative instruments and the policy rate is a pricing instrument.
An increase in reserve requirements takes away from banks a larger proportion of their deposits

and to that extent sterilises their ability to extend credit and create money. This is assuming that simultaneously a central bank will not make a contradictory move to provide liquidity to commercial banks through its discount window. The reverse will be true if the reserve requirements are reduced. A central bank can also add to or subtract from the reserve base of commercial banks through open market operations as a policy tool, thereby affecting their ability to create credit.
The policy rate is the third instrument of monetary policy that affects the demand for credit. But its efficacy would depend on the existence of certain preconditions. The first requirement for the policy rate to be effective is that credit is predominantly utilised by the private sector which operates under competitive conditions and where price signals are allowed to be used for transmission of the impact of policy rate changes to the rest of the economy without any interference.
Second, the economy should be fully monetised and the banking sector and money and capital markets sufficiently developed so that access to bank credit is widely shared by all sectors of the economy and all segments of the population. Third, the banking sector should be highly competitive and properly regulated to act as an efficient financial intermediary between savers and borrowers. Moreover, elasticity of demand for credit and supply of savings in the private sector in relation to interest rates should be high. Fourth, the nominal rate of exchange should be market-determined reflecting underlying conditions, or a fixed rate managed flexibly and, assuming capital account convertibility, capital movements across borders should be sensitive to interest rate differentials.
Most of the developed countries meet the above prerequisites and their central banks primarily use policy rate to regulate the volume and cost of credit and thereby contain liquidity within the limits that ensure achievement of their inflation targets and promotion of fuller utilisation of material resources and full employment of labour force. Occasionally, they supplement the policy rate by the use of quantitative techniques as was done by the Federal Reserve Board in the last several years of recession and by the European Central Bank more recently.
Pakistan’s economy does not meet several of the vital requirements to ensure efficacy of changes in policy rate as an instrument of monetary policy. First of all, the private sector has been relegated to a secondary position in the use of credit because the bulk of it is being siphoned off by the public sector to finance expenditure of the government and public sector enterprises. In other words, bank credit is pre-empted by the public sector and its volume is determined by budgetary needs of the government and not by policy rate of the SBP. Moreover, the SBP is compelled to refinance commercial banks through its discount window if the deposit base falls short of meeting the government’s credit requirements.
The government also borrows from the SBP directly, based on fiscal needs, and creates high powered money with which the lending potential of commercial banks is increased. In a situation in which the public sector is the main user of credit, changes in the policy rate would not change the volume of credit it uses because that would be determined by the deficit in the fiscal operations of the public sector.
The policy rate may have some relevance for a few large borrowers from the private sector who can still borrow from commercial banks and make more profits from a lower rate structure. Accordingly, they always use their lobbying and political power for lowering the policy rate. The small savers who are equally affected by changes in policy rate are not even counted because they lack lobbying and political power to protect their vital economic interests.
The requirement of elasticity of demand for credit and supply of savings in relation to interest rates is also not met in Pakistan for various institutional, social and religious factors. Pakistan is a saving deficit country but the government has made no effort to even understand the importance of increasing the rate of saving to finance higher investment. The international capital flows are also not responsive to interest rate changes in the conditions prevailing in Pakistan.
For the policy rate to become an effective instrument of monetary policy, the SBP should first work on limiting the scope of government borrowing from the SBP and commercial banks based on monetary policy considerations. The SBP is empowered to do so in the revised SBP Act. All that is needed is courage and competence to enforce the relevant provisions so that the government becomes a residual, and not the leading, borrower from the banking system.
Second, monetary policy should be completely divorced from fiscal policy and the SBP should become de facto autonomous as guaranteed by law. Third, commercial banks should be regulated so that they function as efficient and equitable financial intermediaries between private savers and private borrowers rather than being financiers of the government and the big private sector borrowers at the cost of small savers.
If the SBP does not have the competence and courage to fulfil its statutory responsibility for creation of preconditions for an effective use of policy rate, it should have the honesty to abandon pretensions that it is autonomous in formulating monetary policy and regulating the money supply.
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