July 10, 2006	Monday	Jumadi-ul-Sani 13, 1427

THE policy adopted at the last NCCC meeting belied the hopes of an improvement in the central bank’s regulatory attitude following the change in its leadership. The committee resolved to continue the old practice of basing the target for broad money expansion on the sum of the projected growth in GDP and inflation.

Most textbooks on macroeconomics recommend the monetary expansion formula adopt by the central bank, but the variables it is based on eventually disprove all projections about them.

Monetary managers everywhere spend their energies in fighting the intermittent fires ignited by excessive credit expansion or by inflation overshooting the target but in spite of such experiences, monetary managers are yet to devise a better basis for pegging monetary growth.

Even in well-managed economies, monetary management is a challenge. In a recently de-regulated market like Pakistan where economic statistics lack credibility, and market players simply refuse to accept the crucial importance of prioritizing market stability over profitability, basing monetary growth on this formula can be twice as challenging. Nevertheless, NCCC has accepted this tough challenge, yet again.

With GDP expected to grow by seven per cent and inflation expected to stay (some hope!) at 6.5 percent, broad money growth target is 13.5 per cent. It implies that the targeted monetary expansion is 0.7 per cent over the FY 06 target of 12.8 per cent but below the actual (14.8 per cent) growth during FY 06. The target shows lukewarm concern for remedying the monetary overhang that has characterized the economy since FY 03.

In view of the falling domestic savings, market expectation was that monetary growth target will be set lower that in FY 06 to check inflation, encourage savings and convince the government to cut its current expenditure so that the combined private-public demand-pull did not exert upward pressure on interest rates. However, the monetary policy decisions smell of compromises for maintaining ‘economic growth’, a highly deceptive expression.

Central bank does not appear too keen on containing inflation in spite of its claims about monetary ‘tightening’ and ‘frequent’ market interventions. The statement “projected monetary expansion is supportive of real GDP growth target” conveys that impression. The illusive quest for growth (that makes the rich richer and the poor poorer) is a political slogan that is losing its gloss. Anyone overly supportive of this cause would be acting unwisely.

Growth should not be the first priority of central banks; it should be price stability since it affords an even playing field to all stakeholders and thus helps contain economic inequalities and distortions. In this context, a big un-addressed distortion is the reward small savers (constituting two-thirds of banks’ deposit base) get while banks continue to reap questionable benefits. The same is true for the small and medium-sized borrowers – the sector that is now the focus of every financial sector reform without offering much in practical terms.

Galloping bank profitability reflects a weak regulatory profile. The hope that moral suasion will encourage banks to espouse a higher sense of social responsibility is an illusion; in de-regulated markets that allow banks to grow too powerful too quickly, it does not work. In a recent TV talk show, the president of a local bank vouched to remind the central bank to mind its own business, if the central bank pointed a finger at the abnormal rise in banks’ profits.

We wish NCCC success in its endeavour but its past record does not build high hopes. The real level of inflation would remain anybody’s guess all the time and achieving the targeted GDP growth too seems unlikely. Revelations by Dr Ikhtiar Baig of FPCCI about the dwindling competitiveness of the textile sector, and complaints about water and power shortages and escalating fuel costs, from both agriculture and industrial sectors, defy the hope about seven per cent GDP growth.

Given this shaky start, the Rs459 billion expansion in credit appears excessive because neither the economy will generate fresh savings to this extent nor can the industry genuinely consume this much credit. With domestic lending rates rising slowly but surely, domestic demand will contract but more worrisome is the slow but definite recession in the economies of Pakistan’s trading partners, which will hit exports.

In fact, we missed the FY 06 export target because of the setting in of this trend beginning the third quarter of FY 06. To complicate things more the BoP deficit at $11.5 billion is now at an all time high and likelihood of the rupee’s exchange value adjustment appears inevitable. With crude oil price already over US$ 75/bbl, inflation could rise quickly, drastically reducing domestic savings.

In this backdrop, even if the banking sector (judged grossly unfair by the savers) attracts the kind of savings needed to expand credit by Rs459 billion, who will be its recipient? Financing industries, that are lamenting the loss of competitiveness due to the rise in their overall costs, could be risky. Such credit may remain blocked in un-saleable inventories or trade credit extended lavishly by the borrowers to hold on to buyers that could otherwise slip away.

The question this scenario poses to the regulators is whether this should be the disposition of the nation’s savings. Current profitability of the textile sector – biggest consumer of credit – is not very encouraging. Even top performers display amazing ratios in their published financial statements. For instance, a 1 to 10 (much worse in some cases) relationship between post-tax profit and interest paid on borrowings should be worrying for prudent banks.

This is the height of inefficiency (a lot of it caused by the country’s poor physical infrastructure) because it persists even after substantial modernization of plant and machinery costing over $5 billion. According to Dr Ikhtiar Baig, after this expensive revamp, the return earned by the sector before accounting for bank interest and taxes is only five per cent.

According to him, with bank interest forming 3.79 per cent of the overall cost and tax levies eating up another 1.5 per cent, the sector actually earns a negative return. It is therefore not surprising that APTMA had recently demanded a relief and incentive package amounting to Rs50 billion, for its members. The request was wisely and politely turned down by the SBP Governor. In this scenario, it seems that higher credit will only succeed in keeping these units alive.

The issue of greater significance is the projected government borrowing. While the finance bill included a figure of Rs140 billion under this head, NCCC has projected this demand to be Rs130 billion. According to NCCC’s working paper “had privatisation and bond receipts not been realized, [in FY 06] government borrowing for budgetary support would have been around Rs235 billion”. This gives an idea of how unpredictable and de-stabilizing can be the level of government borrowing.

Government circles claim that huge direct investment ($10 billion from Saudi Arabia and $20 billion from UAE) is about to flow into Pakistan. The fine print in these announcements includes conditionalities such as an enabling environment, stable fiscal policies and law and order, and availability of requisite physical infrastructure, which make you wonder about the certainty of these inflows.

The fall out from the PSM privatisation fiasco may delay future privatisations and the proceeds there from may not arrive in time upsetting the government’s projected plan for plugging the resource shortfall. Hoping about privatising PSO, OGDC and NIT by end 2006 is sheer over-optimism. On top thereof, if government ministries do not cut their current expenditures (of which some harrowing details recently emerged) resource shortfall could escalate further.

If all these promises remain unfulfilled, government borrowing could substantially overshoot its target of Rs130 billion, which could lead to a liquidity crisis. If the government does not agree to pay market rates for borrowing (as in FY 05 and 06), it may opt to borrow from the central bank by issuing debt paper that may not be not monetized, as it did before. This approach to resource creation (i.e. printing currency) could push inflation to unmanageable levels.

The right approach was to address the monetary overhang and set the monetary expansion target below the FY 06 level. Besides, it is unwise to disregard the possibility of domestic and global economic slowdown resulting in low GDP growth.

In spite of these oversights, the central bank may still manage monetary and credit expansion with some success but for that it will have to track, practically on a real-time basis, the real level of inflation and credit expansion to take timely remedial steps; this is imperative for remedying the monetary overhang – the real problem.