Inflation-oriented monetary policy and helplessness on rising fiscal deficit
There is a consensus among economists that the gradual change in the interest rate does not trigger much larger effects on the health of the economy in the short run. The global economic perspectives now give the impression that policy makers are willing to cut interest rates even at the cost of higher inflationary pressures in the economy
By Syed Kanwar Abbas

The simple economic theory offers the logical reasons to manage monetary aggregates because the heavy dose of money supply will turn into accelerated inflationary pressures in the long run. The interest rate is considered to be an important instrument of monetary policy to intervene in the major macroeconomic indicators of the economy. Although there is a consensus among economists that the gradual change in the interest rate does not trigger much larger effects on the health of economy in the short run. The global economic perspectives now give the impression that policy makers are willing to cut interest rates even at the cost of higher inflationary pressures in the economy.

The Federal Reserve along with fiscal stimuli of $150 billion decided to cut the interest rate to 3 per cent in the presence of inflation at 4.1 in December 07 to counter US recession with the hope that all this will lead to stimulate economic activities in the economy. On the other hand, The European Central Bank is not planning to change its current interest rate of 4 per cent in near future though the higher euro zone inflation of 3.2 per cent is associated with the surge in food and fuel prices. The euro zone growth is not as highly volatile as compared to other larger economies. Similarly, the Bank of England is also expected to cut interest rates though inflation can exceed from its targets. Common to all this, these economic moves are linked up with the curative measures to overcome and/or absorb the expected severity of global financial crisis. In particular, the rise in the discount rate to 10.5 per cent by the Central Bank in recently released the monetary policy statement for the second half of FY-08 is not linked up with the recessionary period for the economy. The Central Bank is of the view that the higher inflationary pressures, widening fiscal and current account deficits are the major imbalances which led to the continuity of the tight monetary stance in the remaining half of the FY-08. However, it is also arguable that the measures of the Central Bank to reduce inflation would not work in full swing in the presence of higher prices of POL products and palm oil in the international markets.

The burgeoning inflationary pressures

The economy remains under serious inflationary pressures reaching the level of 8.8 per cent (YoY) in December-07. Though it is lowered by 0.1 percent in the same month last year, the annual inflation target of 6.5 percent will be missed at the end of fiscal year-08.

The food inflation stands at 12.2 percent in Dec-07 against 12.7 percent registered in the same month of the last year. The food inflation has struck a double digit level due to rise in the prices of some key food staples like wheat, rice, vegetable, ghee etc in the commodity market.

The core inflation (i.e. NFNE) has also started rising and stood at 7.2 percent in December-07 against 5.7 percent in the same month of the last year.  The food inflation has risen up to 12.2 per cent in December FY-08 which was 12.5 per cent in the previous month of November FY-08. The non-food inflation seems to increase consistently in the ongoing fiscal year. It has reached 6.3 percent in December-07 from 4.9 percent in July-07, the beginning of FY-08. 

The current trend of higher inflationary pressures can have negative effects on the path of growth momentum for the economy. This requires curbing the growth of monetary aggregates which is targeted at 13.7 percent for FY-08. Therefore, the Bank continues its tight monetary policy operations in the MPS for second half of FY-08.

Features of MPS for H2 FY-08

The Bank took a number of policy measures in its H1 MPS FY-08 which also included recommendations to the government to follow quarterly and annual ceilings on budget borrowings from SBP and use balance domestic debt strategy (i.e. using long term financing sources). The SBP advised the government to reduce its borrowing from SBP and diversify its borrowing sources in FY-08. The similar strategies have been used to control inflationary pressures in the H2 MPS FY-08 which inter-alia include the following remarkable measures as described below:

(1) The policy discount rate has been raised to 10.5 per cent from 10 per cent an increase of 50 basis points.

(2) CRR has been raised by 100 basis points to 8.0 per cent for deposits of maximum one year maturity. It has been tried to initiate the mobilization of long term deposits.

(3) SBP has already introduced Long Term Financing Facility (LTFF) to promote the export-led environment in the country. Under this scheme, financing up to 10 years will be provided to the borrowers for purchasing input items both from local and foreign markets.

(4) Another positive move observed in the MPS is the compensation to the private and public sector enterprises that unfortunately bore losses with the tragic fact of the 27th Dec. 2007. The affected enterprises would be given incentive based packages to revive their economic activities in the short period.

The Central Bank’s measures of adopting tight monetary policy have shown positive effects on economic indicators; especially core inflation was reduced during FY-06 & FY-07. 

According to SBP the further tightening of monetary policy is a right policy option for the time being to achieve the GDP growth target of 7.2 per cent and achieve inflation target of 6.5 per cent in the remaining half of FY-08.

Government’s helplessness on rising fiscal deficit

The aggregate demand pressures in the economy are putting constraints on the part of the government to maintain its fiscal deficit within the limits of the Budget Estimates 2007-08. These demand pressures can be exploited with the exploration of new channels of revenue mobilization in the economy.

The Central Bank blames that the fiscal imbalances are creating complications for the successful operations of monetary policy. Government borrowings have crossed both quarterly and annual ceilings which may lead to increase monetary growth and, thus also disturb other macroeconomic indicators.

The central bank has already warned the government to diversify its borrowing sources as almost 60 percent of budget deficit has been financed from the commercial banks and central bank for the July 1 to January 20, FY-08. However, government remained unable to meet its fiscal deficit and, as a result, Central Bank funded Rs237 billion to budgetary expenditures from July 1 to Jan 19 of FY-08 against only one third of this amount in last fiscal year. However, the measures of tight monetary policy have also showed reduction in the reserve money growth from Rs166.5 billion in July 1 to Jan 19 FY-07 to Rs116.2 billion in July 1 to January 19 FY-08.

Government is adopting expansionary fiscal policy measures despite facing fiscal constraints. During the first half of FY-08, a number of factors unknown at the time of budget-making have led to disturb budgetary balances. Some factors have been reported below causing exorbitant fiscal deficit

(a) Lower than expected tax revenue collection: The net federal government revenue receipts have decreased from Rs419.8 billion in July-Dec FY-07 to Rs391.5 billion in July-Dec FY-08. The major dint was observed in the collection of direct taxes from the level of Rs176.5 billion in July-Dec FY-07 to remain only at Rs163.9 billion in July-Dec FY-08. On the other hand, the non tax revenue also decreased from Rs173.5 billion in July-Dec FY-07 to Rs148.9 billion in July-Dec FY-08 (See Table 2).

(b) Excessive increase in the government expenditures: The increase in federal government expenditures has not been off set by the increase in net federal receipts. Expenditures have grown excessively in comparison to increase in federal receipts. The total current expenditure has reached Rs588.2 billion in July-Dec FY-08 against Rs458.7 billion in the same corresponding period of last year. On the other hand, the development expenditures stood at Rs144.4 billion in July-Dec FY-08 while it was Rs93.8 billion in the same period of FY-07. This reveals that total expenditure stood at Rs732.6 billion in July-Dec FY-08 against the previous level of Rs552.5 billion in July-Dec FY-07 (See Table 3).

(c) Increase in interest payments on domestic debt: Another fiscal imbalance was observed with the rise in interest payments on domestic debt. The amount on servicing of domestic debt is Rs205.5 billion in July-Dec FY-08 against Rs131.2 billion for the corresponding period in the last year. The Budget Estimates 2007-08 shows Rs318.2 billion for servicing of domestic debt. However, if this trend continues, the servicing of domestic debt would roughly be doubled crossing Rs400 billion against the budget estimates of Rs318.2 billion at the end of FY-08.

(d) Fall in net external inflows: The net external financing was estimated at Rs193.1 billion in budget estimates 2007-08. In this context, the monthly average of net external inflows should be roughly Rs16 billion. However, the total net external financing is estimated at Rs61 billion instead of around Rs80 billion during July-Nov FY-08. This shows a decrease of almost Rs20 billion against the prescribed budget targets.

(e) Subsidies on petroleum products: Government is adopting the soft corner policies for its masses and has not yet shifted over the effects of higher international oil prices hovering at almost $100 per barrel in the international market. These provisions of higher subsidies on petroleum products have disturbed the government budgetary targets of FY-08. There was no idea of such an exorbitant hike in the international oil prices at the time of budget making.

(f) Privatisation proceeds: The budget estimates 2007-08 mentions that an amount of Rs75 billion would come as privatization proceeds in FY-08. However, the amount of privatization proceeds has been delayed leading to an increase in the deficit.

TABLE-1: MONETARY AGGREGATE FLOWS

(Rs Billion)

Source: SBP               

 TABLE-2: FEDERAL GOVT. REVENUE RECEIPTS

Source: MoF