The SBP needs a major shift from the policy of stabilisation to a policy for stagflation
he world seems to have travelled back in time to the decade of 1970s. It is again plagued by oil crises, currency turmoil and rising unemployment. The deadly combination of high inflation and low growth in 1970 gave birth to a new term, stagflation. A strong recovery from Covid-19 amid the disrupted supply chains triggered a rise in commodity prices. The Ukraine war shot oil, gas and food prices further up. Stagflation is back.
Faced with the additional twin crises of balance of payment and political instability, Pakistan is experiencing great stagflation with average inflation around 25 percent and GDP growth expected to remain low (1 percent to 2 percent) in FY2023. Unprecedented monsoon flooding in the country has made things even worse. A prolonged and more severe period of stagflation lies ahead.
Approximal 35 million people — a fifth of the country’s 220 million population — have been affected by the raging floods. Initial estimates by the Ministry of Finance suggest that floods have caused a staggering loss of around $30 billion. This means the floods have already erased almost 10 percent of the country’s GDP of $347.743 in 2021. This is a big number for a country having already poor infrastructure and facing one of most serious economic crises.
Floods have already inundated about 45 percent of the country’s cropland, posing a serious threat to food security and adding to the already high inflation. The common Pakistani is badly trapped into loss of income and livelihoods on the one hand and rising prices, on the other. This has eroded the purchasing power of the people, particularly that of the bottom-income groups.
On the one hand, the floods have suppressed the GDP growth further down. On the other hand, the loss of crops and disrupted supply chain has added further to the already historic high food inflation. Riding on the food inflation of 30 percent, headline inflation stood at 27.26 percent in August 2022. We are into stagflation. Additionally, increased rice, wheat and other food imports due to crops loss will put pressure on the rupee.
Managing stagflation is a difficult task. More so far Pakistan that is trapped in the quad crises of economic meltdown, implementation of a tough IMF programme, political instability and natural calamity. The government seems to be running out of options. Floods have badly hit almost 20 percent of the country’s population. Instability rules politics. Rupee continues to slide under speculative pressure.
Worryingly, the country’s policy options to fight stagflation are very limited. Contractionary monetary and fiscal policies to correct the balance of payment crisis under the IMF programme — which requires raising interest rate, cutting expenditures, erasing subsidies, raising taxes — will continue to suppress economic growth on the one hand while the increase in the petroleum and energy prices under the programme for fiscal consolidation will continue to push inflation further up, on the other hand. Ground for prolonged stagflation is fertile.
Unprecedented supply chain disruption and loss of livelihoods and economy in Pakistan have prepared a classical breeding ground for long-term stagflation. Already five decades high, inflation in Pakistan is on the rise. Year-on-year CPI-based headline inflation stood at 27.3 percent in August, doubling from 13.8 percent in May. Month-on-month, it increased from 24.93 percent in July. The average inflation between July and August increased by 26.10 percent this year against 8.38 percent over the same period last year.
Food inflation is really testing people’s nerves. Year on year, it stood at 28.8 percent in August where inflation for perishable food items was 33.85 percent. Weekly inflation stood at 45 percent in the third week of august, against the same period last year. If the SBP’s forecast is any guide, inflation seems not slowing down in FY2022-23.
Worryingly, the country’s policy options to fight stagflation are very limited. Contractionary monetary and fiscal policies to correct the balance of payment crisis under the IMF programme will continue to suppress economic growth.
The CPI headline inflation is forecast to remain 18-20 percent against the target of 11.5 percent set by the government for the year. The SBP has not changed its forecast so far. Prior to data on floods and associated economic costs, the IMF had forecast a stagflation with the average inflation of 20 percent and GDP growth of below 3 percent in FY23. Taking into account the impact of floods, the numbers are expected to deteriorate further.
Economists are more divided on how to control stagflation than the question of inflation. The policy options are limited. Policies, such as raising policy rates, may work in inflation but are less effective in stagflation. They can depress economic activity, further complicating the problem. This is why once started, stagflation takes a long time to correct and comes with higher and long-term social and economic costs.
So, what can the government do? The options include a mix of policies. The government needs to simultaneously work on the supply side policies, fiscal measures such as targetted subsidies and closely working with the SBP to bridle volatility in the rupee and slowdown inflation expectations. While implementing a much-needed IMF programme, the government must ensure that people are protected from further loss of purchasing power.
First, the federal government must closely work with its provincial counterparts to limit the adverse impacts on the people affected by the unprecedented floods. Cash assistance will not help immediately as there are no markets available to buy goods. The cash assistance of Rs 25,000 to BISP beneficiaries, therefore, may not help people get food, medicines and other basic necessities of life for a while.
A well-coordinated response is needed for immediate delivery of emergency food, medical, mosquito nets to flood affected population. In the medium term, the government must chalk out strategies to finance the rehabilitation which includes infrastructure development, housing construction and possible relocation.
With a priority focus, the government, as the finance minister has already indicated, must sit with the IMF for a relief in the ongoing programme. Revenue targets need to be adjusted due to floods. As floods have washed out about 10 percent of the GDP, the revenue targets must be cut accordingly, from Rs 7,470 billion to Rs 6,723billion. Slashing revenue targets from petroleum levy and electricity price hike can significantly ease out inflationary pressure.
To ease food inflation, the government must ensure supply of food items in a timely manner. This will require a proactive approach to assess the food security situation across the country and take necessary measures. The government must open trade with neighbours at least to ensure the supply of basic food items. Reducing the demand-supply gap to the possible minimum through timely import of food and other commodities can reduce the inflationary pressure.
At the same time, the government must engage district price control committees to control profiteering and hoarding. It is significantly adding to the already high prices of perishable commodities in particular. Evidence suggests that continued communication with the market to show the commitment of maintaining future supply of goods can help reduce prices and inflation expectations.
On the fiscal front, the government has very limited options. Under the IMF programme, it has to cut subsidies on the energy and petroleum products which essentially means increasing their prices. However, the government has two options at hand that can help minimise the inflation burden on the public at large. First, it must talk to the IMF and reduce taxes, particularly GST, on food items of basic need. Further, it can reduce import duties on food-related inputs.
Second, targetted social protection policies aiming at protecting the purchasing power of the people can help. The BISP must increase cash transfers to the beneficiaries by at least 25 percent. This will require an additional budget of around Rs 48 billion for the BISP. Additionally, the BISP needs to add new beneficiaries by adjusting the cut point for inclusion in the BISP.
As long as we are in the IMF programme, energy and petroleum prices are likely to remain high. The government, therefore, must continue to expand Sasta Petrol Scheme. This relief of Rs 2,000 per month can be provided to around 20 million households already registered with the BISP under Rashan Riayat programme. This requires an additional finance of Rs 40 billion a month, or 240 billion for the next 6 months.
While Rs 240 billion for the next 6 months may sound a large amount, the government can boost the purchasing power of 20 million out of 37.5 million households in the country by spending 28 percent of its targetted revenue of Rs 855 billion from the petroleum levy. It may sound a big ask initially, but it is essential to avoid hunger amid the already eroded purchasing power of the people. The government has to find ways to do it.
Though not fully recognised in Pakistan, the central bank has a critical role to ease out stagflation by arresting inflationary pressures. A successful fight against stagflation needs slowing down inflation. Cooling down inflation expectations is critical.
The SBP, therefore, must work on two dimensions. The exchange rate management comes first. Similar to the stagflation of 2008 when the rupee depreciated slightly above 27 percent during January to December 2008, steep depreciation of rupee is adding to current stagflation with a history-high inflation of above 27 percent.
The SBP must arrest the speculative pressure on the rupee. The sharp rise and fall of rupee — the spikes coming from speculative pressure — are making the currency very volatile and creating panic in the market. The volatility limits gains from appreciation of the rupee as market expects the currency to slide down — and slide down even further — very soon. Prices, therefore, remain unchanged at the higher level and do not adjust downward with the gain in rupee.
On September 6, the rupee was trading at 233.5 a dollar in the open market against the interbank rate of 219 a dollar — a gap of Rs 14.5. The gap dropped but from the wrong side. Instead of recovering in the open market, the rupee dropped in the interbank trade to 239 a dollar on September 20, mainly due to continued speculative pressure in the open market, which is so strong that even the news of extension of the Saudi deposits did not reverse the slide.
On the monetary policy front, the SBP needs a major shift from the policy for stabilisation to a policy for stagflation. A contractionary monetary policy may not only be totally ineffective in controlling inflation but also suppress economic activity, further adding further to stagflation. The SBP may keep the status quo. Given the overwhelming supply-side nature of inflation and economic slowdown and IMF conditions, the SBP should keep the policy rate unchanged upward. A forward guidance may help calm the market.
The writer is the deputy executive director at the Sustainable Development Policy Institute (SDPI). He tweets @sajidaminjaved. The views in the article do not represent an SDPI position