STATE BANK’S ANNUAL REPORT
Assessment of current state of
the economy and its future prospects
Poor domestic commodity production combined with excess demand and some high import prices have been inferred to cause annual inflation to increase to 12 per cent during 2007-08 and further to 25 per cent in the first quarter of the current year

By Dr Mushtaq Ahmad

The current state of the economy assessed by the State Bank in its latest annual report is dismal. The recent policy initiatives have turned out inadequate to check the economic drift. The bank has attributed this to a host of domestic and external developments but it has claimed to have been pursuing a right monetary policy in the process. This paper is focused to examine the bank’s prognosis for the economic situation and explains how the bank has itself been helpless in exercising its autonomy in conducting a monetary policy.

The growth has plummeted in both industry and agriculture. The past policy gains realised in achieving macroeconomic stability have been offset; the fiscal deficit climbed from 4.3 per cent of GDP to 7.4 per cent during 2007-08; the current account deficit accelerated from 4.8 per cent for GDP to 8.4 per cent; inflation (CPI) risen from 7.8 per cent to 12 per cent (WPI risen from 6.9 per cent to 16 per cent and SPI from 9.4 per cent to 14.4 per cent); the rupee depreciated heavily and the forex reserves depleted to an unsatisfactory level. These developments have adverse implications for the poor. The low income group has remained subjected to comparatively higher inflation of 10.71 per cent during 2006-07 and 14.26 per cent during 2007-08 “which shows that inflation affects the poorest segments with high intensity”.

Not to underestimate the importance of the services sector but the fact remains that the commodity production is the structural base of the economy and all determinants of the macroeconomic stability hinge on that. In turn this is dependent on investment and capital formation. The annual report indicates that the slowdown in GDP growth was mainly due to lacklustre investment resulting from the investors’ cautious response to political uncertainty, law and order and inflation. During 2007-08 the contribution of investment demand in GDP remained the lowest in last four years at 0.7 per cent. Energy shortage, capacity and input constraints caused the industrial growth to decline sharply from 8 per cent to 4.6 per cent. Major crops recorded a negative growth of 3 per cent in contrast to 8.3 per cent and agricultural growth declined from 3.7 per cent to merely 1.5 per cent. Its causes included water shortages at critical sowing time, incidence of viral attacks, dis-proportionate rise in fertiliser and pesticides prices, procurement price problem of cotton and sugarcane and not announcing price policy by the government before sowing time.

The bank finds the largest contributor to the deteriorated situation is the sharp jump in the fiscal deficit and its monetisation. The government has been for years living on monetising fiscal deficit but in recent period the non debt creating sources of budgetary borrowings have dried up. The government borrowings from the State Bank for financing the gap amounted to Rs688.7 billion, about 90 per cent of the total government financing requirements. This directly impacted the three key areas of the economy. It raised the government debt and MRTBs stock with the State Bank rose from Rs452.1 billion to Rs1,053 billion. It pushed the reserve money growth to 21.9 per cent and eventually strengthened the inflationary trends.

The report states that these developments stoked the aggregate effective demand which in turn pushed imports. High international oil and food prices reinforced this trend. Lower domestic production on the one hand affected exports while on the other hand increased imports to meet local shortages. The generosity of foreign donors, so prominent in the preceding years for a front line coalition partner in the war on terror, lost its tenor. Resultantly the current account deficit has increased to an alarming level.

Poor domestic commodity production combined with excess demand and some high import prices has been inferred to have caused annual inflation to increase to 12 per cent during 2007-08 and further to 25 per cent in the first quarter of the current year.

Before I take up the bank’s policy recommendations and evaluate their adequacy and robustness, a few passing remarks are deemed necessary on the analytical quality of the report itself. Some of its individual chapters make a fascinating reading for economists as a good reliance in their analysis, as professionalism requires has been made on some empirical econometric studies, using Ganger causality, segregation of types of adjustments etc. But that is not adequately portrayed in sketching the Outlook and similarly in laying out the recommendations.

The bank is obsessed with excess liquidity notion and as in the past it has repeated some what the same profile of recommendations. The cure of the high fiscal deficit is sought through matching revenues with expenditures, increase in tax elasticity and buoyancy, and lesser official price intervention. We all know that that is very much required but what is expected of the bank with a huge skilled ability and capacity is an explanation of why the government efforts continuing for long in that direction have failed and what specific steps need to be taken.

When the bank referred to the price interventions that meant regulation mainly of energy prices. Market failures and their abnormal behaviours rightly require government intervention in the larger interest of the society. No responsible government can afford to watch markets playing havoc as an unmoved spectator and wait for a proverbial invisible hand to correct the situation in the long run (when we all as Keynes said will be dead). Strangely the bank in a chapter on growth criticised the government for not taking timely support price measures. Stricter trade regime has been appreciated; is it not stepping up the price intervention?

The bank has been allowed autonomy in the conduct of monetary policy through legislation. It has criticised the government for over borrowing and bypassing the fiscal responsibility act. Why did it allow the government over borrow? Why has the private sector been crowded out in the credit market? Now by raising the bank rate, would the government borrowing be reduced significantly and the private sector not suffers once again? Would the higher bank rate improve the savings rate? Have the past interest rates Ganger caused the savings rates and consumption? The Fed in the US should serve a role model for our central bank. Monetary and Fiscal Coordination Committee is a high level forum to protect its autonomous status. In a recent commitment with the IMF, an inter agency committee will be set up to review and strengthen the legal provisions relating to the operational independence of the SBP. The time will tell how the bank plucks up the courage to play its legal role rather than singing its ritual song through the annual reports.

Surprisingly the bank has lamented its own intervention in the foreign exchange market and quoted research studies to support a view point that “any attempts to hold on to any particular exchange rate in the face of a fundamental imbalance, would have been futile and resulted in an even faster depletion of reserves”. This notion has implicitly been aligned to the conditionalities recently agreed with the IMF. Are there any prospects of elimination in the near run of the fundamental imbalance in external sector which is stubbornly persisting with increasing intensity over the past six decades? Exchange rate stability left at the mercy of the fundamental imbalance would entail heavy policy trade offs. Many other countries faced with an imbalance are interfering in the market and have achieved a success; India being one such example.

Internal and external adjustments are advised in the report to take care of the current account deficit. In common man’s language these are reduction in liquidity and rupee depreciation in real terms. This may or may not work but it is certainly not supported by the bank’s own analysis of the causes in a chapter on BOP. The causes infact include unprecedented global and commodity prices, slowdown in textile exports, higher demand due to domestic shortages etc.

The bank has already increased the policy rate and duties on many imports have been increased. The landed import prices would certainly increase but most of the imports as also reviewed in detail in the report have inelastic price demand. So, how will the dynamic equilibrium move? Aggregate supply will squeeze and the planned liquidity reduction will suck some of aggregate demand. The eventual outcome will lead to further accentuation of the existing stagflation like situation. The statement of the bank that most countries in the current financial turmoil have raised the bank rate as a corrective measure; this is factually not correct. Even an IMF note on “Questions and Answers on Pakistan Programme” dated 3rd December placed on its website (Q:4) also contradicts that. This reads: “Q4. Why is the Fund asking Pakistan to raise interest rates when in other countries the Fund is suggesting monetary easing? (A) The Fund believes that each country's interest rate policy should reflect its own situation and economic objectives…”

The real problem facing our economy is its failure to tap its commodity production potentials. No monetary policy incentives have been proposed to promote the supply side. There is an impending crisis in irrigation water. The trade and industry has already agitated against the hike in interest rate. The proposed increase in gas and electricity rates as also agreed with the IMF would be a further input for cost push inflation. The exchange rate conditionalities agreed with the IMF and also underlined in the report are proposed to be implemented over the coming year and the rupee would further sink.

As one of the targets of the IMF package is a further slowdown in GDP growth to 3.5 per cent during 2008-09 from 5.8 per cent as also projected in the report. This coupled with 20 per cent inflation projected and severe reduction planned for aggregate demand means one more shock for the poor and fixed salaried government employees already marginalised due to a persistent denial of wage indexation.

— (The writer is a former Chief Economist of Pakistan).