September 29, 2003	Monday	Sha’aban 2, 1424

The rise in foreign exchange reserves held by the banking system, especially the State Bank of Pakistan (SBP), has been lauded on the following grounds:

i) they serve as a tool of exchange rate and monetary policy management; ii) funds are readily available for servicing external debt and liabilities; iii) they provide defence/cushion against unanticipated shocks; and iv) they help in upgrading the credit rating of the country. (SBP Leading Issues Facing Pakistan Economy, pp.215-217). Here we take up the first objective of increase in foreign exchange reserves relating to facilitation of monetary policy management..

Impact on monetary assets: Monetary assets increased by Rs670 billion, from Rs1401 billion in June, 2000 to Rs.2071 billion in June, 03. They rose by Rs126 billion (or 9.0 per cent) in 2000-01, by Rs235 billion (15.4 per cent) in 2001-02, and by Rs309 billion (17.5 per cent) in 2002-03, or at an average compound rate of 14 per cent.

The analysis of factors contributing to growth in monetary assets showed that increase in foreign exchange reserves held by the banking system accounted for Rs589 billion (88 per cent), while the rise in domestic credit was responsible for Rs81 billion (or 12 per cent). The year-wise break-up shows increasing contribution of net foreign assets to monetary expansion: Rs73 billion (58 per cent) in 2000-01, Rs206 billion (87 per cent) in 2001-02, and Rs310 billion (100 per cent) in 2002-03.

The economy has tended to save a larger proportion of income in the form of monetary assets. The ratio of quarterly average level of monetary assets to GDP at current market prices increased from 42.9 per cent in 2000-01 to 45.7 per cent in 2001-02, and further to 48.4 per cent in 2002-03. However, as pointed out above, the bulk of these savings went to finance sharp rise in net foreign assets of the banking system, primarily through purchase of home remittances and retaining these to boost up forex reserves.

At the same time, the substantial inflationary gap (defined as percentage increase in monetary assets minus percentage growth in production of agriculture and manufacturing sectors) at 7.4 per cent, 13.3 per cent, and 11.8 per cent respectively in the past three years ended June, 03 should be a cause of concern to the economic managers. More importantly, the increase in public’s savings could not materialize into rise in investment, production and employment.

The contribution of net foreign assets of the banking system to monetary expansion during 2003-04 is likely to be the same as in the preceding year, i.e. around Rs300 billion. This estimate is based on the following assumptions. First, the flow of home remittances would remain at the preceding year’s level and it would not be diverted from banks to money changers. Secondly, government would be unable to use a significant amount of foreign exchange resources for development of infrastructure of the economy due to constraint on overall level of deficit financing.

On the other hand, government would continue to borrow heavy amounts from IFIs under schemes such as poverty reduction and growth facility (PRGF), just because these are soft-term loans and are not counted towards budget deficit. Under this accounting approach, the implications of the unproductive use of such foreign borrowings for the economy would continue to be ignored. Thirdly, private sector’s demand for foreign resources will remain subdued as private fixed investment is unlikely to rise significantly.

Impact on domestic credit: The following implications of increase in the NFA for the domestic credit of the banking system are worth mentioning:

1) There was a sharp decline in the growth rate of domestic credit of the banking system over the past three years. Whatever the reasons, this was necessary to restrain the growth rate of monetary assets within a sustainable level.

2) Net domestic assets of the SBP declined from Rs359 billion in June, 2000 to Rs353 billion in June, 2001, further to Rs256 billion in June, 2002, and still further to Rs94 billion in June, 2003. This was attributable primarily to the decline in SBP’s holdings of government securities in its portfolio in lieu of its so-called policy of sterilization of liquidity (i.e. reserve money) injected into the money market through purchase of foreign exchange in the inter-bank market (i.e. from commercial banks). At present, only a small amount of government securities is left in the portfolio of the SBP.

3) During 2003-04, if the expectation of the level of inflow of home remittances into commercial banks at approximately last year’s level materializes, and the government does not resort to large scale borrowings from the banking system to meet fiscal deficit, then the SBP would perforce have to issue its own securities with a view to sterilizing liquidity (i.e. reserve money) injected into commercial banks through purchase of foreign assets from them.

With an army of advisors at its command, at wages equivalent to the standards prevailing in IFIs, the SBP has yet to announce the issue of its own securities, their period of maturity, level of rates of return on them, whether tradable in money and capital markets or not, etc. as a tool of sterilizing excess liquidity in the money market.

4) The increase in scheduled banks’ claims on government sector far exceeded the rise in their total domestic credit and, as a result, they constituted 34.9 per cent of total domestic credit in June, 03 as against 28.7 per cent in June, 02 and 20.4 per cent in June, 01. The ratio would have been much higher in June, 03 but for the scam pertaining to commercial banks’ credit to the private sector during FY03 discussed below. It is pertinent to point out that commercial banks’ credit to the private sector is denoted to have risen by Rs.152 billion in FY03, as against Rs7 billion in FY02 and Rs48 billion in FY01.

Impact on interest rates: The entire spectrum of interest rates registered sharp decline in the past two years owing to excessive injection of liquidity following purchase and accumulation of foreign exchange reserves. The decline was more pronounced in the case of Pakistan Investment Bonds and Market Treasury Bills, whose return fell from the range of 11.6 - 14 per cent to 1.4 - 5.6 per cent in the past two years. The interest rates on scrips issued under National Savings Schemes (NSS) were also reduced from 14 per cent in June, 2001 to 10 per cent in June, 2003 in the case of Defence Saving Certificates, and from 11 - 12 per cent to 8.5-9 per cent over the same period in the case of registered Special Saving Certificates.

The weighted average monthly lending rates of nationalized and privatized domestic banks declined from 13.5 per cent and 14.8 per cent in June, 01 to 6.7 per cent and 6.9 per cent respectively in June, 03; while deposit rates fell from 4.4 per cent and 4.1 per cent to 1.6 per cent and 1.3 per cent respectively over the same period.

Scam: The decline in interest rates at an uneven rate gave an opportunity to the unscrupulous persons in business and banking sectors to indulge in interest rate arbitrage. Of the total increase of Rs141 billion in savings mobilized under NSS and the sharp rise of Rs152 billion in commercial banks credit to the private sector during FY03, Rs30 billion according to Press reports, is attributable to interest rate arbitrage. Keeping in view the past trends, this figure of Rs.30 billion seems to be an underestimate. In some quarters, this figure is placed at more than Rs60 billion. This misuse of savings placed with the banks is not only shameful but also highly pernicious to the economy. The SBP will be well advised to look into this matter closely, disclose the correct position, and recommend an exemplary punishment for the persons involved in this scam.

Profitability: SBP i) The profit of the SBP is already under pressure. The decline of Rs.217 billion in high-yield government securities and rise of Rs.310 billion in low yield foreign assets in its portfolio during FY03 alone will adversely affect its profit for the year. The issue of its own securities in the near future would also have an adverse impact on its profit, depending on the rate of interest offered on these securities.

ii) Scheduled banks: The increase in share of government securities in total domestic credit from 20 to 35 per cent, coupled with sharp decline in interest rates on government securities is likely to adversely affect their profit. At the same time, the decline in rate of interest on fresh credit to the private sector will also have adverse impact on profit. The rates of interest on deposits were reduced sharply to maintain profitability resulting into negative real returns to depositors.

(The writer is former Economic Adviser of the State Bank of Pakistan.)