Shamshad Akhtar: Monetary policy in Pakistan
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the Federation of
Pakistan Chambers of Commerce & Industry, Karachi, 30 April 2007.
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Mr. Tanvir Ahmed Sheikh, President FPCCI, Mr. Zubair Tufail, Vice President FPCCI and Mr. Sheikh
Amjad Rasheed, Chairman FPCCI Committee on Banking, Credit, & Finance
Background
Monetary policy management and financial sector stability are two primary roles of State Bank of
Pakistan (SBP). Monetary policy and process of its formulation in Pakistan has undergone changes
with the evolving economic dynamics within the country and the improved empirical and theoretical
understanding of the monetary policy across the world.
Monetary policy in Pakistan, in line with SBP Act, has been supportive of the dual objective of
promoting economic growth and price stability. It achieves this goal by targeting monetary aggregates
(broad money supply growth as an intermediate target and reserve money as an operational target) in
accordance with real GDP growth and inflation targets set by the Government. Over the years, while
maintaining the broad legal mandate, SBP has improved the quality of monetary formulation and its
process quite significantly.
This morning, I propose to first outline measures taken by the Government and SBP to strengthen the
monetary policy management. Second, I will discuss the rationale and key elements of SBP current
monetary policy stance which I believe is helping bring down inflation without stifling credit or
economic growth. Finally, I will discuss the impact of SBP's policy actions, and challenges in its
implementation.
Changes in monetary policy management
SBP shifted its reliance from an administered monetary policy regime governed by ad hoc changes in
reserve ratio's, directed credit and regulated interest rate policies in mid 1990s to a liberal and market
oriented monetary policy management. Abolishing sector and bank credit limits, central bank adopted
"3-day SBP discount rate" as a major policy instrument to signal easing or tightening of monetary
policy which essentially responded to the demand pressures of the economy in line with the growth
trends in monetary liabilities and monetary assets - with former capturing the growth in currency and
deposit base and latter the growth in domestic credit (including both government borrowings and
private sector credit).
Generally monetary module of the economy is the least understood area. This is largely because
monetary segment of the economy deals with on one hand the changes in stocks and flows of money
supply and on the other hand trends in it subsumes and defuses the impact of developments of fiscal
and balance of payments accounts. Notwithstanding both sides of the balance sheet of monetary
accounts impact price behavior.
As highlighted above, broad money supply growth has to be consistent with the targets of growth in
real GDP and inflation rate. However, if there are excessive demand pressures either because of high
fiscal deficit or because of the excessive foreign inflows money supply grows faster than the growth in
productive sectors and generates demand pressures which manifests itself in rise in inflation rate.
Despite all contests and debates, inflation is primarily a monetary phenomenon. To keep it under
control it is critical that macroeconomic imbalances are kept within the permissible limits. Fiscal
profligacy in the past has resulted in Government's unlimited recourse to low and fixed interest rate
financing. While interest rates were kept low to nurture private sector credit growth - this did not
traditionally happen as private sector investment remained subdued due to host of structural problems
facing the economy. Instead low interest rates nurtured fiscal indiscipline as the Government
continued to borrow at cheaper rates to finance expenditures.
Recognizing this dilemma, qualitatively monetary policy formulation and its implementation underwent
profound changes. In 1997, SBP and its Central Board were empowered to formulate, conduct and
implement monetary policy and a Monetary and Fiscal Coordination Board was established to ensure
fiscal policy is well coordinated with the monetary policy - specific provision of SBP Act mandates
Central Board to impose limits on Government's central bank borrowing. In 2005, the Fiscal
Responsibility and Debt Limitation Act 2005 requires Government to reduce its revenue deficit to zero
by 30th June 2008 and maintain it thereafter, and concurrently reduce public debt to sixty percent of
GDP by 2013 and below that limit thereafter. Compliance with the two pieces of legislation has been
underway and over the period will help in eventually curbing more effectively Government's recourse
to central bank borrowing - which traditionally has complicated monetary policy management.
With greater powers to formulate monetary policy, SBP moved to market oriented monetary policy
where it relied more on interest rate to serve as a policy fulcrum and developed its capacity to manage
financial markets and related activities effectively. Proactive conduct of monetary operations and
management of market volatility has helped improve market flows. The Open Market Operation (OMO)
process has been institutionalized with better flexibility vis-à-vis tenors and frequency.
In 2005, SBP introduced the Money Market Computerized Reporting System (MM-CRS) for banks
which helps in assessing the market liquidity. SBP's treasury operations and gradual improvements in
its liquidity management have together helped OMOs and money market development.
Current monetary policy stance
Public, businesses and market needs to develop understanding that monetary policy does indeed,
over the long run, determine the behavior of the price level. While inflation is precipitated by supply
price level
shocks, hoarding, official restrictions, import prices, and so on, but these influence in a
given year. However, it is monetary policy that can prevent an effect on the rate of inflation over a
more extended period. That is, following the initial price level shock, an appropriate adjustment of the
interest rate (if necessary) can stop a potential second round of repercussions on wages and prices.
Specialists use measures of core inflation, which exclude volatile prices, as a way to see through
oneoff shocks. Core inflation is very useful to the central bank itself, as a guide to the appropriate setting
of its monetary policy stance. Unexpectedly low (high) core inflation usually indicates the need for
easing (tightening) in the policy stance.
The ultimate objective of a central bank, and the measure of success of its policy, is in terms of overall
(i.e. headline) inflation. In this context, the way to deal with price level shocks is to stress their
temporary is
nature with respect to the inflation rate. This involves: ensuring that the effect on inflation
only temporary - this may or may not require a policy action, and realizing that as monetary policy
influences the trend of prices with a lag of at least a year and a half, headline inflation should return to
its pre-shock rate not within not 1 year but 2 years.
Price signals in a market economy operate less effectively when the price level is unstable; in addition,
resources are diverted to unproductive speculation and hedging. Thus, countries with unstable price
levels - high inflation or deflation - almost always experience weak output and growth. Thus, low
inflation is not merely an end in itself, but also a means to good overall economic performance.
The main cause of high interest rates is high inflation, through the expected-inflation premium.
Conversely, the best prospect for low interest rates is a stable environment of low inflation. In this
context, the relatively high interest rates that may be necessary to achieve a desired disinflation
represent "short-term pain for long-term gain". SBP, therefore, has a current focus on anti-inflation
policy which will ensure steady growth in the long run.
Since April 2005 in response to the headline inflation reaching 11.3%, SBP has been and remains in
monetary tightening phase. It has to be recognized that the inflationary pressures build up in 2005
because of the preceding few years of easy monetary policy. While SBP addressed this overhang by
raising policy discount rate from 7 to 9% in April 2005, there were renewed demand pressures as
fiscal and external account deficits rose in wake of both international oil price increase as well as
unforeseen spending demands triggered by the earthquake. To offset additional demand pressures,
SBP had to further raise its policy discount rate by 50bp in July 2006 along with 4.5 percentage point
upward revision in reserve ratios.
In line with the evidence observed for developing countries, impact of monetary tightening on curbing
inflation started to be visible after 12-18 months or so. As aggregate demand pressures moderated,
CPI fell to 7.9 percent in FY06 (remaining well within the annual target of 8%) and CPI continued to
decline to 7.7% in March 2007 with core inflation being still low at 5.4%. However, CPI remains above
annual target of 6.5% largely because of a number of factors that disrupted the impact of monetary
tightening:
(i) food prices remained quite volatile during FY07 due to supply disruptions;
(ii) higher fiscal pressures resulted in greater than planned recourse to the central bank
borrowing. More specifically, government has borrowed Rs. 180 billion for budgetary support
by 14 April 2007 compared with only Rs. 37 billion during the same period last year. During
the later part of FY the Government has been retiring part of the central bank borrowing and
financing its deficit by external flows or commercial bank borrowings;
(iii) heavy borrowing from commercial banks seems to have been crowding out private sector
borrowing for long-term investment as banks find it convenient to park their funds in
government securities rather than lending;
(iv) SBP being mandated to provide higher than projected refinancing for the textile sector -
besides its high borrowing to meet working capital requirements through EFS, textile
exporters were allowed debt swap and new long term borrowings which ranged around Rs50
billion; and
(v) higher than expected foreign inflows are expected to enhance the levels of net foreign assets
and result in monetary expansion.
Together these factors have resulted in 16.9% YoY growth in reserve money by 14 April (compared to
11.2% last year) which has translated into broad money supply growth of 17.3% by 14 April 07 -
higher than the monetary policy statement's original projection of 13.5%.
To avoid adverse impact of monetary tightening on investment demand in the economy and the
longrun growth momentum, SBP has ensured proper liquidity management. Not only have the overnight
rates been kept close to the discount rate, but the volatility in the short-term interest rates also reduced
during H1-FY07. 6-months KIBOR rose by 58 bps to 10.2% during July-April 07 and banks weighted
average (marginal) lending rate has increased from 9.9 % in June 2006 to 10.5 % in February 2007.
During July-April 14, net credit to private sector grew by Rs266.4 billion (or 12.6 %) against Rs 339.7
billion (or 19.8 %) in the corresponding period of FY06. Despite liquidity in the system, commercial
banks are not able to lend because of low demand for private sector's credit that has borrowed quite
heavily in last few years. While there has been growth in working capital, the demand for fixed
investment has been subdued. In some cases, corporate sector is further meeting their demand either
from retained earnings or foreign borrowings. In some sectors, banks have deliberately slowed down
to now assess and develop their own capacities to lend more prudently. The process of mergers and
acquisition in a number of banks also impact private sector credit as most "acquired banks" slowed
down their business.
Trends in key macroeconomic variables indicate that SBP monetary policy stance has proved
successful in striking the required balance between curbing the demand side inflationary pressures
and supporting the growth momentum. Indications are that the economy continues to grow at a robust
pace on account of acceleration in Large-scale Manufacturing (LSM) and agriculture, and the
persistently strong performance of services sector.
More importantly, core inflation, which had registered a sluggish decline in FY06, has already
witnessed a substantial deceleration during the first nine months of FY07. By March 2007, YoY core
inflation has come down to as low as 5.4 percent, which is 1.25 percentage points lower than the 6.7
percent level recorded during the corresponding period last year, 0.9 percentage points less than the
level observed in June 2006. This comforting decline in core inflation, however, is eclipsed by the
persistently high food inflation stemming principally from supply side disturbances. In totality, the
average consumer price index (CPI) saw a rise of 8.0 percent during July-March FY07 relative to the
annual target of 6.5 percent for FY07.
With inflation in Pakistan being relatively higher compared to its competitors and trading partners, the
Relative Price Index (RPI) increased by 5.8 percent during first three quarters of FY07. Higher
domestic inflation has offset the gains emanating from nominal depreciation and the real exchange
rate, measured in terms of the real effective exchange rate (REER) index, appreciated slightly by 2.5
percent during first three quarters of FY07.
Conclusion
To conclude, so far, the current monetary policy posture appears to be striking the balance of
gradually reducing the excess demand pressures from the economy, without prejudice to the
highgrowth prospects. In the short-term, SBP will need to maintain its monetary tightening stance and
enhance its communication to influence inflation expectations, and effectively communicate that
concerns about the adverse effects of higher interest rates on competitiveness and/or growth are ill
founded as the real interest rates in Pakistan are low relative to its competitors.
However, it is important to recognize that monetary policy alone will not be able to contain the rise in
inflationary pressures. The Government will need to continue to alleviate supply-side constraints
because of problems of market structure and distribution system. Success in containing inflation
further depends on continued effective monetary management which requires minimizing
Government's recourse to central bank borrowing, mitigating the monetary pressures arising from the
surge in capital flows ensuring that these are sterilized and keeping refinancing within manageable
limits, while complementing these measures with check and vigilance on food prices.
Going forward, SBP will be launching preparatory work on inflation targeting. There will be need for
introducing supportive legal and regulatory framework which allow for targeting inflation and allow
greater operational independence to the central bank, while ensuring that SBP has the desired
transparency and communication strategy critical for transition to an eventual adoption of inflation
targeting.