Coordination of fiscal and monetary policies
By Aftab Ahmad Khan

Monetary policy is concerned with the regulation of the quantity, cost and allocation of money and credit in the economy. Fiscal policy refers to government’s programmes of public spending and its resource mobilisation strategy for meeting these expenditures.

Fiscal and monetary policies are closely related to each other despite the fact that these sets of policies are sometimes different in terms of scope, transmission mechanisms and time involved in influencing the economic variables.

Fiscal and monetary policies have profound impact on the level and composition of savings, investment, output and employment as well as viability of the external account. It is the effective combination of fiscal and monetary policies that can help augment savings and direct investment efficiently while avoiding domestic inflationary pressures and excessive balance of payments deficits. Unfortunately in many developing countries these objectives have not been met. Inadequacy of voluntary savings in the face of excessive demands on them has frequently led to heavy credit expansion which in turn has distorted resource allocation, generated speculation in financial and asset markets and has led to both adverse distributional effects and severe strains on balance of payments. As a result, both equity and growth have suffered.

The basic responsibility of macro-economic management consists of sound management in the short run and supply expansion over the long term. Fiscal and monetary policies have to be not only appropriate but mutually consistent. One important objective of fiscal policy is the need to abjure unsustainable fiscal deficits in view of their inflationary and balance of payments consequences. Fiscal policy has also an important role in promoting savings not only in the household and corporate sectors through modulated tax policies but also as an instrument of enhancing public savings through a well designed tax policy and through adequate resources from the operation of public enterprises by levying appropriate user charges; public policies on the spending side can determine the investment pattern especially in the field of social over-head capital and this can play an important role in poverty alleviation. The allocation of public funds is no less important than mobilising them.

Monetary policy in the context of economic management and development has both functional and institutional dimensions. The functional dimension relates to the responsibility for price stability and should be concerned with maintaining an appropriate balance between expansion of money supply and availabilities of goods and services. A growing economy needs expanding money supply owing to the extension of the monetised sector and increasing cash balance requirements of the community. As money supply expansion has its counterpart in the growth of monetary assets of the central bank, the concern with ensuring an appropriate degree of monetary expansion (i.e. without engendering inflation) translates itself into a rational allocation of monetary assets in the form of claims on government and private sectors. Experience of Pakistan and several other developing countries show that large fiscal deficits have led to excessive claims on government sector crowding out the rest of the economy and leading to excessive monetary expansion. In such a situation the room for manoeuvre for the monetary authority tends to be restricted to attempting to offset the distortion by limiting the secondary expansion of credit; again, in several developing countries including Pakistan owing to structural and institutional factors, credit to sectors of national importance such as agriculture and small business and industry is often inadequate and a promotional monetary policy is necessary to ensure sufficient availability of credit for these priority sectors. The other area of responsibility is with regard to the cost of money i.e. interest/mark up rates. It is desirable that interest/mark up rates be positive in real (inflation adjusted) terms as an instrument for avoiding excessive credit expansion.

In Pakistan, the Ministry of Finance and the State Bank of Pakistan (SBP) coordinate fiscal and monetary policies to ensure that as far as possible these policies move in the direction of achieving development objectives in a stable milieu. More specially, among other things, the Ministry of Finance is closely associated with the formulation and approval of the annual credit plan, while the governor of the SBP attends the meetings of the economic coordination committee of the cabinet. The Ministry of Finance and the State Bank are also represented on the National Economic Council.

Under the SBP Amendment Act passed in 1997, the central board of directors of the SBP has the authority to determine the monetary policy independently and has to submit a quarterly report to the parliament on the state of the economy. There is, however, a coordination board to determine the extent of the government’s borrowings from the commercial banks and ensure that the overall expansion of the liquidity in the economy is within the limits proposed in the annual credit plan. It cannot be denied that after the promulgation of legislation guaranteeing the autonomy of the SBP, its freedom has been substantially enhanced. The State Bank, however, formulates its policy after taking into account the targets set by the federal government for growth, inflation, balance of payments and revenue generation.

Pakistan experienced uncomfortably large fiscal deficits during the 1970s, 1980s and 1990s. During the 1970s, the annual average rate of this deficit as a percentage of gross domestic products (GDP) was 5.3 per cent. During the decade of the 1980s, the annual average rate of the deficit increased to 7.1 per cent of GDP while during the 1990s, it came down slightly to 6.9 per cent. During 2000-01 to 2004-05, the deficit showed a welcome decline to an annual average of 3.7 per cent of GDP. During FYs 2005-06 and 20006-07, the annual fiscal deficit has been estimated at 4.3 per cent of GDP. During the current fiscal year (FY08), the target for fiscal deficit is 4 per cent of GDP, however, on the basis of latest reassessment it appears that its magnitude may be around twice the target. The overall rate of inflation at end – fiscal FY08 is now projected at 10 per cent against the target of 6.5 per cent and actual of 7.8 per cent last year.

In the case of a developing country like Pakistan, the appropriateness of the magnitude of the fiscal deficit is to be judged with reference to what is sustainable in the medium and long term. A sustainable deficit can simply be defined as the deficit level that can be financed without imposing excessive burden on the economy and without violating governments macro-economic objectives such as low inflation, and real economic growth at the socially necessary rate which in our case is at lest 7 per cent per annum.

The efficacy of monetary policy based primarily on quantitative credit planning depends on the accuracy of economic projections on which it is based. Any variance between projections and actual trends in economic growth could result in misestimating monetary expansion.

Monetary expansion in Fiscal years 2000-01 to 2005-06 has been significantly higher than the original targets as well as the growth in GDP. The average annual expansion in monetary assets during this period was 16.1 per cent while the annual average growth in GDP was 5.5 per cent. In 2006-07, while GDP growth was 7 per cent, monetary expansion was 19.3 per cent and inflation as measured by consumer price index (CPI) was 7.8 per cent. In the current fiscal year, monetary expansion is now projected at around 19 per cent against the target of 13.7 per cent almost entirely due to increased government borrowing from banks.

In conclusion, it may be emphasised that at present the dominant challenge for our fiscal and monetary managers aside from vigorous efforts at resource mobilisation is to strike an appropriate balance between output growth, equitable distribution of income, poverty reduction and structural change. The theme of achieving the goals of economic development and change simultaneously with those of stability and equity has been sharply emphasised in recent years.