Shamshad Akhtar: The effectiveness of monetary policy in Pakistan
Speech by Dr Shamshad Akhtar, Governor of the State Bank of Pakistan, at the convocation
of the Institute of Business Management, Karachi, 6 December 2008.
* * *
A. Introduction
Economic policies aim to increase the welfare of the general public, and monetary policy
supports this broad objective by focusing its efforts to promote price stability. Embedded in
this objective is the belief that persistent inflation would compromise the long term economic
prospects of the country. The objective of monetary policy in Pakistan, as laid down in the
SBP Act of 1956, is to achieve the targets of inflation and growth set annually by the
government. In pursuit of this mandate, SBP formulates the country's monetary policy that is
consistent with these announced targets. In my remarks today, I plan to provide perspective
on:
•
First, why central banks focus on price stability?
•
Second, how the monetary policy transmission mechanisms work?
•
Third, what are the principal features of Pakistan's monetary policy framework?
•
Fourth, selected thoughts on effectiveness of Pakistan's monetary policy framework
• Finally, what measures are needed to improve the effectiveness of the monetary
policy framework in Pakistan?
These questions have been a subject of much debate lately, as monetary tightening - an
inevitable policy response for regaining macroeconomic stability - has aroused anxiety but
better public understanding of this question will help them to appreciate central bank's
monetary policy stance.
B. Why focus on price stability?
Before getting into other intricacies of monetary policy, it is useful to bring forth the
importance of price stability as an overriding objective of monetary policy. Actual inflation
outcome in the economy is driven largely by the level of output gap (the difference between
what the economy is demanding and what it can potentially produce) and inflation
expectations. When the output gap widens, the actual output is more than what the economy
can sustain in the long run with stable inflation. This reflects excessive demand for available
resources in the economy, which pushes up general prices. In order to stem the increase in
resource cost and the general price level in the economy, this gap needs to be narrowed or
stabilized. This can be achieved by either reducing the demand in the short run or increasing
the productive capacity over the medium to long run. Reducing aggregate demand, however,
entails reduction in current output and an increase in the unemployment level in the
economy.
The famous classical Phillips curve that captures the trade-off between stabilizing inflation
and controlling unemployment was criticized by Phelps and Friedman in the late 1960s. They
argued that if inflation expectations react to changes in actual inflation, then any trade-off
between inflation and unemployment would be short-lived at best. If wages are set once a
year and for some reason the output prices increase, then the producers have an incentive to
increase their output by hiring more workers. However it is only possible if workers'
expectations of inflation remain unchanged during the period of increase in output prices. If
workers adjust their expectations in accordance with actual inflation and demand higher
nominal wages, it leaves relatively little incentive for firms to increase the output.
Therefore the focus has shifted away from this trade-off and new consensus has emerged in
the literature that price stability is key to long run growth prospects. Both theory and evidence
suggest that monetary stimulus can only affect real economic activity in the short-run. In the
long run, however, there is no conflict between low inflation and full utilization of economic
resources. Ensuring price stability, in turn, requires effective management and anchoring of
inflation expectations.
With stable prices, economic decisions can be made with less uncertainty and therefore
markets can function without concern about unpredictable fluctuations in the purchasing
power of money. On the other hand, high and unanticipated inflation lowers the quality of the
signals coming from the price system as producers and consumers find it difficult to
distinguish price changes arising from changes in the supply and demand for products from
changes arising from the high level of general inflation. In the market economy, prices
represent basic means of transmission of information; the increased noise associated with
high inflation lowers the effectiveness of the market system. High and unanticipated inflation
makes it impossible to plan for relatively longer outlook, creating incentives for households
and firms to shorten their decision horizons and to spend resources in managing inflation
risks rather than focusing on the most productive activities.
Ben Bernanke argued that the Fed's mandated goals of price stability and maximum
employment are almost entirely complementary: "price stability is an end of monetary policy;
it is also a means by which policy can achieve its other objectives".1 This argument has also
been supported by Keneth Rogoff (1985) who advocated that the central bank should place
larger weight on inflation stabilization, in order to increase the welfare of the society.
Therefore, the competing goals of growth and price stability, which may seem to be at odds
with each other, in fact boils down to a single objective i.e. price stability. In this backdrop,
there is no surprise that most of the central banks aim at maintaining low and stable inflation.
Central banks place more weight and demonstrate increased willingness on controlling
inflation relative to output growth, and financial and exchange rate stability. It is important to
acknowledge, however, that in practical policy making, adhering to revealed preferences is
rather difficult. The reason is that central banks do not operate in a vacuum and require
coordination with other policy making institutions, in particular the fiscal authority. In addition,
the social and cultural make-up of a country and political economy considerations often
require central banks to accommodate conflicting policies. In other words, sticking to an
announced rule-based monetary policy can be difficult in practice; "enlightened discretion" is
preferred by most central banks. Thus, SBP's decision to focus on arresting the persistent
inflationary trends is tantamount to a pro-growth policy, not a growth retarding one.
C. Monetary policy transmission mechanism
The monetary transmission mechanism refers to a process through which monetary policy
decisions affect the level of economic activity in the economy and the inflation rate.
Understanding the transmission mechanism of monetary policy is crucial for appropriate
design and efficient conduct of monetary policy. As monetary policy actions affect policy
variables with a considerable lag and with high degree of variability and uncertainty, it is
important to predict the possible impact and extent of monetary policy actions on the real
variables. Thus, by its very nature, monetary policy tends to be forward-looking.
It is also important to know which transmission channels are more effective in terms of
transmitting changes in monetary policy actions to ultimate policy goals. Since various
financial sector developments particularly regarding introduction of new financial products,
technological changes, institutional strengthening, and expectations about future policy, etc.
can potentially change economic effects of the monetary policy measures, there is a need to
regularly update, empirically test and reinterpret monetary policy transmission channels.
The impact of monetary policy is perceived to transmit in to the real economic activity
through five channels.
•
The first channel and most widely studied and understood channel of monetary
policy transmission relies on the link between changes in the short-term nominal
interest rate (induced by changes in the policy rate) and the long-term real interest
rate that ultimately affect components of aggregate demand such as consumption
and investment in an economy. As such, it is the changes in the long-term real
interest rates that have its impact on aggregate consumption, business
investment and other components of aggregate demand.
•
The second channel, known as the credit channel, involves changes in monetary
policy that not only affects the ability of firms to borrow money (by affecting their net
worth) but also affects the ability of banks to lend money. The strength of this
channel depends on the degree to which the central bank has allowed banks to
extend loans and the dependence of borrowers on bank loans. These factors are
clearly influenced by the structure of the financial system and its regulation.
•
The third channel of monetary policy transmission focuses on asset prices (other
than the interest rate) such as the market value of securities (bonds and equities)
and prices of real estate. A policy-induced change in the nominal interest rate
affects the price of bonds and stocks that may change the market value of firms
relative to the replacement cost of capital, affecting investment. Moreover, a change
in the prices of securities entails a change in wealth which can affect the
consumption of households.
•
Fourth, a policy-induced change in the domestic interest rate also affects the
exchange rate that in turn affects the foreign financial flows, net exports and thus
aggregate demand. The strength of the exchange rate channel depends on the
responsiveness of the exchange rate to monetary shocks, the degree of openness
of the economy, sensitivity of foreign private inflows and net exports to exchange
rate variations, and the net worth of firms and thus their borrowing capacity if they
have taken exposure to foreign currency. Moreover, exchange rate changes lead to
changes in the domestic price of imported consumption goods and imported
production inputs affecting inflation directly.
•
Since expectations influence the inflation dynamics, there is a fifth channel that is
based on the economic agents' expectations of the future prospects of the economy
and likely stance of the monetary policy. According to this "expectations channel",
most economic variables are determined in a forward-looking manner and are
affected by the expected monetary policy actions. Thus, a consistent, credible, and
transparent monetary policy can potentially affect the likely path of the economy by
simply affecting expectations.
D. Monetary policy framework in Pakistan
Considering the economic and financial market structure in Pakistan, SBP has for sometime
pursued a monetary targeting regime with broad money supply (M2) as a nominal anchor to
achieve the objective of controlling inflation without any prejudice to growth. The process of
monetary policy formulation usually begins at the start of the fiscal year when SBP sets a
target of M2 growth in line with government's targets of inflation and growth (usually in the
month of May) and an estimation of money demand in the economy. The basic idea is to
keep the money supply close to its estimated demand level, as both a significant excess and
a shortfall may lead to considerable deviations in actual outcomes of inflation and real GDP
growth from their respective targets. Underlying this framework are two strong assumptions:
first, there is a strong and reliable relationship between the goal variable (inflation or real
GDP) and M2; and second, the SBP can control growth in M2.
While containing the M2 growth close to its target level is the key consideration in the current
monetary framework, the composition of the money supply does matter and at times requires
policy actions even if these actions lead to a deviation in monetary growth from its target
level. To understand this point, it is necessary to know the major components of money
supply and their relative importance. Net foreign Assets (NFA) and Net Domestic Assets
(NDA) of the banking system are the two major components of money supply. The NFA is
the excess of foreign exchange inflows over outflows to the banking system, or in other terms
it is a reflection of underlying trends in the country's external Balance of Payment (BoP)
position. It is estimated by the projected values of all major external transactions such as
trade, workers' remittances, debt servicing, foreign investment, and debt flows etc. The NDA
of the banking system, which primarily consists of credit to the government and the private
sector, reflects changes in the fiscal and the real sectors of the economy. It is estimated as a
residual of M2 and the NFA. Further breakup of NDA is estimated on the basis of projected
credit needs of the government and the private sector.
Now coming to the importance of these components of the money supply, depletion in NFA
is generally considered as an unhealthy development. Sharp NFA depletion reflects
worsening BOP position and a pressure on exchange rate. In such a case, a higher NDA
growth, though helps in expanding M2 to reach its target level, may further deteriorate
external accounts, sharper depreciation of local currency, and higher depletion of country's
foreign exchange reserves. Although since FY07, only the indicative M2 growth target is
being announced, SBP also takes into consideration the causative factors for monetary
expansion while pursing this target.
Considering the changes in monetary aggregates and other economic variables, the changes
in monetary policy are signaled through adjustments in the policy discount rate (3-day repo
rate). Further, the changes in the policy rate are complemented by appropriate liquidity
management mainly through Open Market Operations (OMOs) and if required changes in the
Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also
made.
E. Effectiveness of monetary policy in Pakistan
Significance of various channels that transmit the monetary policy shocks in Pakistan to the
real economy has been analyzed by few economists. Ahmad et al. (2005) found that credit
channel is the most important conduit for transmitting monetary policy actions to the real
economic activity. Evidence confirms transmission through the active asset price channel
and exchange rate channel. According to this study, monetary policy shocks impact real
output after a lag of 7 to 11 months. Tasneem and Waheed (2006), on the other hand,
investigated whether different sectors of the economy respond differently to monetary
shocks. The presence of sector wise differences in the monetary transmission mechanism
has profound implications for macroeconomic management as the central bank then has to
weigh the varying consequences of its actions on different sectors. Investigating the
transmission of changes in interest rate to seven sub sectors of the economy, the authors
found evidence supporting sector-specific variation in the real effects of monetary policy.
They found that the interest rate shock on manufacturing, wholesale and retail trade, and
finance and insurance sectors transmit after a lag of 6 to 12 months. On the other hand,
monetary policy shocks have negligible impact on agriculture, mining and quarrying,
construction and ownership of dwelling sectors.
Generally, historical evidence does reflect that Pakistan has been a high inflation and high
interest economy given its inherent structural weaknesses. The role and effectiveness of
monetary policy appears more visible in the 2000s when financial sector reforms started
bearing fruits in terms of a more market based money and foreign exchange markets.
Entering the 21st century, the loose monetary policy stance in the face of low inflation, low
growth and low twin deficits, along with structural measures to open up the economy and
alleviate some first round constraints, triggered the economy on a long term growth trajectory
of above 7 percent.
Monetary policy stance was however altered as the inflationary pressures started to build up
in 2005. At the end of the fiscal year, the economy, which had been showing sustained
steady growth since FY01, registered a historically high level of growth (9 percent), average
inflation rose sharply (9.3 percent) and the external current account balance turned into
deficit (-1.4 percent of GDP). Coinciding with these developments, the fiscal module started
to show signs of stress as the fiscal balance was converted into a deficit and the stock of
external debt and liabilities, which had been declining since FY00 after the Paris Club
rescheduling, began increasing. These indicators largely capture the high and growing
aggregate demand in the economy on account of sustained increase in peoples' income.
With the emerging domestic and global price pressures, SBP tightened its monetary policy
after a prolonged gap of a few years. The efforts to rein-in inflation, however, proved less
effective due to a rebound in international commodity prices and a rise in domestic food
prices later on. The rise in the international commodity prices, particularly oil, exacerbated
the fight against inflation. The international oil prices (Arabian Light) rose from US$27.1 at
end 2004 to US$50.9 at end 2006, whereas international food prices rose by 24, 24 and 21
percent during 2004, 2005 and 2006 respectively.2
Realizing the complications of monetary management and adverse global and domestic
economic developments, the implementation of SBP monetary policy during FY06 varied
significantly from the preceding fiscal years. In addition to the rise in the policy rate, the
central bank focused on the short-end of the yield curve, draining excess liquidity from the
inter-bank money market and pushing up short-tenor rates. Consequently, not only did the
overnight rates remain close to the discount rate through most of the year, the volatility in
these rates also declined.
These tight monetary conditions along with the Government's administrative measures to
control food inflation helped in scaling down average inflation from 9.3 percent in FY05 to 7.9
percent in FY06, within the 8.0 percent annual target. This was certainly an encouraging
development, particularly as it was achieved without affecting economic growth as the real
GDP growth remained strong at 6.6 percent in FY06.
Monetary policy tightening was strengthened further. For FY07, the government set an
inflation target of 6.5 percent. To achieve this, a further moderation in aggregate demand
during FY07 was required as the core inflation witnessed a relatively smaller decline in FY06,
indicating that demand-side inflationary pressures were strong. In this perspective, SBP
further tightened its monetary policy in July 2006 raising the CRR and SLR for the scheduled
banks; and its policy rate by 50 basis points (bps) to 9.5 percent. Moreover, proactive
liquidity management helped in transmitting the monetary tightening signals to key interest
rates in the economy. For instance, the Karachi Inter Bank Offer Rate (KIBOR) of 6 month
tenor increased from 9.6 percent in June 2006 to 10.02 percent at end-June 2007 and the
banks' weighted average lending and deposits rates (on outstanding amount) increased by
0.93 percentage points and 1.1 percentage points, respectively, during FY07.
In retrospect, it appears evident that monetary tightening in FY07 did not put any adverse
impact on economic growth, as not only was the real GDP growth target of 7.0 percent for
FY07 was met, the growth was quite broad based. At the same time, the impact of the
monetary tightening was most evident in the continued deceleration in core inflation during
FY07. One measure of core inflation, the non-food non-energy CPI, continued its downtrend
from YoY high of 7.8 percent in October 2005, to 6.3 percent at end-FY06, and to 5.1 percent
by the end of FY07. However, much of the gains from the tight monetary policy on overall
CPI inflation were offset by the unexpected rise in food inflation.
On the downside, however, broad money supply (M2) grew by 19.3 percent during FY07,
exceeding the annual target by 5.8 percentage points. Slippages in money supply growth
largely stemmed from an expansion in NFA due to the higher than expected foreign
exchange inflows.
Equally stressful was the impact of Government borrowings from the central bank during the
course of the year. The pressure from the fiscal account was due to mismatch in its external
budgetary inflows and expenditures. With the privatization inflows and the receipts from a
sovereign debt offering at end-FY07, the Government managed to end the year with
retirement of central bank borrowings, on the margin. By end-FY07, SBP holdings of
government papers were still around Rs 452 billion, despite a net retirement of Rs 56.0 billion
during the year. Another major aberration in FY07 emanated from the high level of SBP
refinancing extended, for both working capital and long-term investment, to exporters. Aside
from monetary management complexities, these schemes have been distorting the incentive
structure in the economy.
FY08 and beginning of FY09 was even more challenging
FY08 was an exceptionally difficult year. The domestic macroeconomic and political
vulnerabilities coupled with a very challenging global environment caused slippages in
macroeconomic targets by a wide margin.
After a relatively long period of macroeconomic stability and prosperity, the global economy
faced multifarious challenges: (i) hit by the sub prime mortgage crisis in U.S in 2007, the
international financial markets had been in turmoil, the impact of which was felt across
markets and continents; (ii) rising global commodity prices, with crude oil and food staples
prices skyrocketing; and (iii) a gradual slide in the U.S dollar against major currencies.
Combination of these events induced a degree of recessionary tendencies and inflationary
pressures across developed and developing countries. Policy-makers were gripped with the
dual challenge of slowdown in growth and unprecedented rising inflationary pressures.
Central bankers faced a demanding task of weighing the trade-off between growth and price
stability. With the exception of few developed countries, most central banks showed a strong
bias towards addressing the risk of inflation and responded with tightening of monetary
policies.
On the domestic front, the external current account deficit and fiscal deficit widened
considerably to unsustainable level (8.4 and 7.4 percent of GDP). The subsidy payments
worth Rs 407 billion by Government, which account for almost half of the fiscal deficit,
shielded domestic consumers from high international POL and commodity prices and
distorted the natural demand adjustment mechanism. While the government passed on price
increase to consumers, the rising international oil and other importable prices continued to
take a toll on the economy.
Rising demand has cost the country dearly in terms of foreign exchange spent on importing
large volumes of these commodities. Rising fiscal deficit and lower than required financing
flows resulted in exceptional recourse of the Government to the highly inflationary central
bank borrowing for financing deficit. At the same time the surge in imports persisted.
As a result, inflation accelerated and its expectations strengthened due to pass through of
international oil prices to the domestic market, increases in the electricity tariff and the
general sales tax, and rising exchange rate depreciation. These developments resulted in a
further rise in headline as well as core inflation (20 percent weighted trimmed measure) to 25
percent and 21.7 percent respectively in October 2008. Considering the size of
macroeconomic imbalances and the emerging inflationary pressures, SBP remained
committed to achieve price stability over the medium term and thus had to launch steeper
monetary tightening to tame the demand pressures and restore macroeconomic stability in
FY09. SBP thus increased the policy rate from 13.5 to 15 percent.
F. What needs to be done to improve the effectiveness of monetary policy?
Apart from taking policy measures to address the emerging challenges, SBP also introduced
structural changes in the process of monetary policy formulation and conduct to make the
monetary policy formulation and implementation more transparent, efficient, and effective.
Specifically, during the last couple of years, SBP focused on
•
Institutionalizing the process of policy formulation and conduct,
• Stepping up movement towards a more market based credit allocation mechanism,
•
Developing its analytical and operational capacity,
•
Improving its capabilities to assess future developments to act proactively, and
•
Improving upon the communication of policy stance to the general public.
However, the following areas need attention and are key for effective monetary
management.
1. Effectiveness of monetary and fiscal coordination would be helpful. Section 9A and
9B of the SBP Act (amended in 1994) articulates the institutional mechanism for
economic policy making and coordination and defines the ground rules for both the
process and the policy making. However, the track record of the Monetary and
Fiscal Policies Coordination Board (MFPCB), established in February 1994 that
requires quarterly meetings of the SBP and the government, has been less than
satisfactory. Furthermore, the sequencing of economy-wide projections is done in
isolation of the budget and monetary policy making process, and the budget making
process has not respected the monetary compulsions. With rising spending and
stagnating revenues, the budget assumes at the start of the year certain recourse to
the central bank rather than treat it as mere ways and means advances.
2. For effective analysis of developments and policy making, timely and quality
information is extremely important. However, due to weaknesses in the data
collection and reporting mechanism of the various agencies of the country,
information is not available with desired frequency and timeliness. Also there are
concerns over the quality of data. Unlike many developed and developing countries,
data on quarterly GDP, employment and wages, etc. is not available in case of
Pakistan. Moreover, the data on key macroeconomic variables (such as government
expenditure and revenue, output of large-scale manufacturing, crop estimates, etc.)
is usually available with substantial lags. This constrains an in-depth analysis of the
current economic situation and evolving trends, and hinders the ability of the SBP to
develop a forward-looking policy stance.
3. Unlike many countries, both developed and developing, there is no prescribed limit
on government borrowing from SBP defined in the SBP Act or the Fiscal
Responsibility and Debt Limitation (FRDL) Act 2005. Besides being highly
inflationary, government borrowing from SBP also complicates liquidity
management. Borrowing from the central bank injects liquidity in the system through
increased currency in circulation and deposits of the government with the banks. In
both cases, the impact of tight monetary stance is diluted as this automatic creation
of money increases money supply without any prior notice. Moreover, access to
potentially unlimited borrowings from the SBP provides little incentives to the
government to put the fiscal accounts in order. Therefore, the foremost task to
improve the effectiveness of monetary policy is to prohibit the practice of
government borrowings from the SBP. In this regard, appropriate provisions are
required to cease or limit government recourse to central bank financing through
amendments in the SBP Act and the FRDL Act 2005.
4. Another issue is to make a clear distinction between exchange rate management
and monetary management. Currently, there is a general perception that the State
Bank is bound to keep the exchange rate at some predefined level and any
movement away from this level is then considered as an inefficiency of the SBP.
There is a need to understand that for an open economy, it is impossible to pursue
an independent monetary and exchange rate policy as well as allowing capital to
move freely across the border. Since the SBP endeavors to achieve price stability
through achieving monetary targets by changes in the policy rate, it is not possible
to maintain exchange rates at some level with free capital mobility. This can only be
achieved by putting complete restrictions on capital movements, which is not
possible. SBPs responsibility is to ensure an environment where foreign exchange
flows are driven by economic fundamental and are not mis-guided by rent seeking
speculation.
5. Finally, based on experience particularly gained during the last two months is to
differentiate between liquidity management and monetary policy stance. Recently,
when the banking system experienced extraordinary stress due to shallow liquidity
in the system, rumor mongering heightened the general public anxiety over few
banks' sustainability. Consequently, the SBP had to intervene in the market by
injecting ample liquidity through various measures. In some quarters, these changes
were deemed as a change in the Bank's tight monetary policy stance. However, this
was not the case and the Bank had to clearly and repeatedly communicate that the
existing stance is being continued. Later on, the Bank further tightened its monetary
policy. It must be understood that quite often, liquidity management can drive the
market interest rates away from the direction desired under the monetary policy
stance. However, this has to be temporary and the interest rates are bound to move
in the policy stance direction. To resolve this issue, the SBP is studying various
options, including the introduction of a "Standing Deposit Facility" to keep the
interbank rate within a corridor.
In conclusion, it is imperative that above steps be taken urgently. Over the period, however,
this needs to be complemented with much deeper structural reforms to synchronize and
reform the medium term planning for the budget and monetary policy formulation process.
Several studies and technical assistance have provided extensive guidance in this area, but
the lack of capacities and short term compulsions have often withheld such reforms. What is
important is to recognize that a medium term development strategy, independently worked
out, would help minimize one agency interest which has often been a source of coordination
difficulties. It would also help the budget making process more rule based than the
incrementally driven process to satisfy conflicting demands.
Reference:
Ahmed N., H Shah, A. I. Agha, Y. A. Mubarik (2005), "Transmission Mechanism of Monetary
Policy in Pakistan," SBP Working Paper Series No. 09, State Bank of Pakistan.
Tasneem, A. and Waheed, M. (2006), "Sectoral Effects of Monetary Policy: Evidence from
Pakistan." Pakistan Development Review, Volume 45, No. 4, Part II winter.
Khan, Mohsin S. and S. A. Senhadji (2001), "Threshold Effects in the Relationship between
Inflation and Growth", IMF Staff Papers, Vol. 48 (1) pp. 1-21.
Rogoff, Kenneth (1985), "The Optimal Degree of Commitment to an Intermediate Monetary
Target", Quarterly Journal of Economics, Vol. 100, No.4, pp. 1169-1189.