December 18, 2006	Monday	Ziqa'ad 26, 1427

THE market based monetary policy regime in place since Dr Yaqub’s governorship of the State Bank (1993–1999) is a major cause of increased dependence on world money markets, the persistence of high levels of poverty and the alarming growth now in income and asset distributional inequalities. To substantiate this claim, this paper uses data from the 2005-06 SBP annual report.

SBP claims that the ‘tight’ monetary policy pursued since the second half of FY05 “has proved to be very effective”. It is not correct because the rate of growth of money supply (M2) has decelerated at roughly the same rate as the rate of growth of real GDP during FY06 (both about 22 per cent). The deceleration of M2 growth may thus be interpreted as an effect - not a cause - of deceleration of GDP growth. Most empirical studies using data for the last decade show that GDP growth Granger causes M2 growth in Pakistan and not vice versa. SBP presents no evidence to the contrary.

In any case, the actual M2 growth during FY06 exceeded the SBP target growth rate by about 19 per cent. The FY06 M2 target had been fixed assuming that GDP would grow by seven per cent in FY 06. GDP actually grew by 6.6 per cent. The implicit M2 growth target therefore works out at about 12 per cent and the excess of actual growth over implicit target is about 27 per cent.

While reserve money growth did decelerate significantly, this did not have a significant impact on the other components of M2. This is evident from a vigorous increase in the money multiplier to an all time high of over 3.3. During FY06 the increase in the deposit multiplier was even sharper and the value of the later exceeded that of the former.

During FY05 private credit growth exceeded reserve money (M0) growth by 95.5 per cent. This excess increased to 130.4 per cent in FY06. During FY06 the private credit growth rate exceeded the rate of growth of nominal GDP by 33.5 per cent. The (statistically insignificant) difference between the growth rates of nominal GDP and M2 growth is entirely attributable to the sharp deceleration in the M0 growth rate (which now accounts for only about 30 per cent of money supply). An inevitable consequence of the institutionalisation of market based monetary policy is the inevitable loss of SBP control on both the domestic and foreign components of money supply. This is the true meaning of SBP “autonomy” which is reflected in the fact that despite the SBP’s sincere intention to tighten monetary policy “monetary growth during FY06 was amongst the highest during the last 15 years relative to the growth in nominal GDP” as the SBP acknowledges.

One aspect of this loss of control is reflected in what the SBP (following its Chicago mentors) conceptualises as “the transmission mechanism”. The SBP report celebrates the increased impact of its OMO auctions on both inter-bank and loan rates. But the ‘transmission mechanism’ is supposed to link the money market to the real economy, as all good practitioners of Voodoo economics know. A tightening of money supply or an increase in interest rates is a means to an end, not an end in itself. “Successful” monetary policy stimulates savings and increases the efficiency of investment (so say the Voodoo economists).

During FY06 a deceleration in M2 growth and a rise in inter bank lending rates has been accompanied by a fall in national savings which according to the SBP “are at their lowest level since FY01”. Domestic saving is significantly lower - probably the lowest in all of Asia. The farcical nature of the claim about the increased “effectiveness of the transmission mechanism” is exposed when the SBP acknowledges that “the saving to GDP ratio did not improve primarily due to prevailing real rates of return on deposits” [p 61]. The savings investment gap now exceeds three per cent of GDP and is now higher than at any time since 1989.

Bank deposit growth rate decelerated during FY06 by about 20 per cent in comparison to FY05. The rate of growth of bank deposits was significantly below the growth of nominal GDP during FY06. Moreover “the transmission mechanism” has worked in the perverse way that it has increased the concentration of bank deposits in the large foreign banks such as Habib Bank and UBL while deposits in small domestic banks fell by 10 per cent in FY06 compared to FY05. Foreign currency deposits of foreign banks rose by over 200 per cent during FY06 while total FCAs fell from Rs37.7 billion in FY05 to Rs18.9 billion during FY06.

Did the “transmission mechanism” lead to more efficient investment growth? Growth in real fixed investment remained well below historical levels and the real fixed investment to GDP ratio is lower for Pakistan than for any other Asian country with the exception of Bhutan and Yemen (no figures are currently available for Iraq, Afghanistan and Laos). That investment efficiency is unlikely to have increased (no evidence to the contrary is presented by the SBP) is evident from the extremely high increase in the investment deflator (measuring cost of investment goods) during FY04, FY05 and FY06. This is mainly due to the speculative explosion of real estate prices and the enormous monopoly profits being made by the wholesale trade, both unavoidable consequences of the casino investment policies fostered by the present government.

Market based monetary policy is an essential constituent of this casino macroeconomic strategy, which generates immiserising growth - growth at the expense of the mustadafeen. The managers of this immiserising growth strategy are not worried about inflation - despite the pretence. CPI is rising at the rate of eight per cent? Food prices at 12 per cent? So what? The income of the generals, the top bureaucrats, the CEOs, the consultants and the other insiders rises at the rate of 100,000 per cent every time they make a deal. Their children can afford to make paper airplanes with Rs5,000 currency notes issued by the SBP in FY06.

“There is a conscious decision” says the SBP “to reduce inflation gradually (emphasis SBP’s), since attempts to hasten the pace of disinflation ran the risk of destabilising the system. Thus the targeted inflation reduction in FY06 was very modest”. This target is likely to be even more modest in the future.

As the SBP recognises “the rising trend in WPI and the GDP deflator indicates that inflationary pressure persists in the economy”. The SBP absolves itself of the responsibility of a substantial portion of the rise in consumer prices by subtracting from the CPI index growth in food and fuel prices or by “trimming” (i.e. cutting) the mean index by 20 per cent. (The SBP turns a blind eye - probably is not even aware of - the severe restrictions formulated by its Chicago mentors circumscribing the interpretation of this “trimmed” measure).

Even this emasculated “core” (CP1 shows that the fall in inflation “has been very gradual and remains very high” according to the SBP. Moreover this trend has been reversed since June 2006 and in September 2006. CPI, “core” inflation, WPI and the GDP deflator were all significantly higher than in June 2006. The 6.5 per cent CPI growth target set by the SBP for FY 07 is already unrealisable.

Several empirical studies have shown that inflation affects the lower income groups much more severely. On average, the cost of living of households with an income below Rs10,000 per month rises 29 per cent higher than the annual increase in CPI - and this is of course a gross underestimate since CPI does not measure a large proportion of their expenditure.

The SBP’s claim that “inflation is finally responding to monetary policy” is incorrect since extensive empirical research shows that price changes are supply driven and money supply (M2) is itself an endogenous variable determined by movements in real GDP. The failure to reduce inflationary pressure through monetary measures is confirmed by the significant increase in the liquidity ratio of the banks during FY06. Indeed SBP acknowledges that it “was not concerned to achieve liquidity shortages but (only) to ensure lesser volatility in overnight rates”. To what purpose?

The FY06 “Credit Plan” (it is of course merely a credit forecast) graphically illustrates the extent of monetary policy failure: In FY 2006 monetary assets growth exceeded credit plan “targets” (forecasts) by 18.6 per cent. Net foreign assets (NFA) growth excess was a whopping 243.3 per cent. Private sector credit grew by 22 per cent more than planned levels and Other Items Net (ONA) contracted significantly (figures in FY05 and FY06 are not comparable) more than forecast due to slowdown in government borrowings from the SBP.

This manifest loss of control of SBP over both domestic and foreign components of money supply has had a truly devastating impact on the distribution of credit. This becomes evident when we compare figures for 1999 and 2006 (end June).

In 1999 deposit accounts with less than Rs10,000 each equalled 51.5 per cent of all accounts. The total amount in these accounts equalled 11.3 per cent of total scheduled bank deposits. In June 2006, these account holders equalled 26.1 of the total scheduled bank deposit accounts but their share of total bank deposits had dropped to 0.8 per cent.

In June 1999 deposits with more than Rs10 million each accounted for about 0.1 per cent of the total number of deposit accounts and their share of the total deposit amount was 13.3 per cent. In June 2006, the share of these account-holders in the total number of accounts was 0.07 per cent. Their share in total bank deposits had however gone up to 34.5 per cent.

In 1999 investment accounts with a credit limit of Rs10,000 equalled eight per cent of total advance accounts. Their share of total bank credit was about 0.15 per cent. In 2006 such accounts equalled a little less than 2.9 per cent of total advance accounts and their share in total advances of all banks in Pakistan was 0.04 per cent (not 0.1 per cent as claimed by the SBP).

In 1999 the share of the total number of accounts with credit limits in excess of Rs10 million was 0.2 per cent, while their share of total bank credit was 45.7 per cent. In 2006 the share of such accounts in total advance accounts had risen to 0.3 per cent but their share in total bank credit had increased to 65.5 per cent.

This largest group of bank clients had total deposits of Rs972 billion in June 2006 but total credit extended to them exceeded Rs1.1 trillion. As against this, the smallest group of bank clients (those with Rs10,000 each) deposited Rs24 billion but were extended credit of only Rs800 million - only 3.3 per cent of their deposits - in June 2006.

In the light of these statistics SBP’s calculations of the Herfindhal Index measuring “sectoral concentration” can only be taken as hypocritical.

The banking system has become parasitical and exploitative. The major cause of this is privatisation involving the take-over by foreign groups of our financial markets. Bloated profit rates are sustained by both assets and liability management - the preference for trade financing, the stimulation of credit card business and monopolist acquisition of financial assets - all of which the SBP celebrates.

The claims about decline in non-performing loans are not credible since no figures are provided for cash collections, rescheduling and most importantly write-offs - which are unprecedentedly high.

In 2006 ZTBL alone wrote off over Rs24 billion. Moreover as the SBP says “the improvement in the commercial banks’ non-performing loans (NPL) is attributable entirely to provisioning”. Gross NPLs of commercial banks increased by Rs4 billion during FY06 despite a commercial bank write- off of over Rs8 billion.

The enhanced profitability of the major banks - most of which are now foreigner dominated - is mainly due to the widening spread between deposit and loan interest rates. The spread between the weighted average rates of return on advances and deposits increased from 7.44 per cent in June 2005 to 8.65 per cent at end June 2006 - a rise of 16.13 per cent. The increase in the banking sector’s profitability during FY06 in due to two factors only - the enormous growth in interest spread and the concentration of banking business at the top and the short end of the market. Both these trends are represented in the decline in the number of deposit accounts and the number of bank branches.

In June 1999 there were 29.8 million deposit accounts in the scheduled banks. This has fallen every year since then. On June 30, the number of deposit accounts had fallen to 26.2 million. The average number of depositors per account holder has been estimated (in 2005) by NBP researchers to be 1.9 - this means that out of a population of about 155 million there are only about 13.8 million deposit holders. Over 90 per cent of the people never open a bank’s door.

The number of bank branches has declined from 8,058 at end June 1999 to 7,412 by June 30, 2006. Bank branches have declined at roughly the same rate at which the population has grown during the Musharraf era. The country is now by far the lowest banked country in Asia. This is elite orientation with a vengeance. The SBP continues to promote this elite orientation by forcing through the acquisition of local banks by foreign conglomerates, by discriminatory application of Basle 11 and Prudential Regulations on small domestic banks, by encouraging a programme of union bashing and employment retrenchment throughout the industry and above all, by the continued refusal to abandon market based monetary policy.

The SBP is an inefficient - not merely an ineffective - organisation. During Dr Ishrat Hussain’s governorship - 1999–2005 - it lost Rs51 billion on exchange rate transactions. During FY06 this cumulative loss was reduced by a paltry Rs4.3 billion (down from an exchange transaction profit of Rs13.8 billion during FY05). Thus during Musharaf’s rule the SBP has lost Rs47 billion while the Reserve Bank of India’s gain on foreign exchange transactions exceeded Indian Rs620 billion during this period. The SBP apologises for this near 70 per cent decline in exchange rate gain by referring to the relatively slower decline of the rupee against the dollar in FY06 as against FY05. This is not true. It seems the SBP has no professional capabilities in foreign exchange markets and is a powerless recipient of currency market shocks. It has not heard of swaps, arbitrage deals and currency structured transactions.

Moreover Ishrat Hussain lost Rs14 billion in 1999–2000 when the rupee depreciated by 1.4 per cent and he lost Rs50 billion in exchange rate transactions in FY01 when the rupee devalued against the dollar by over 22 per cent.

Why does the SBP not diversify the reserves portfolio? Why is the share of the euro; the renminbi and the yen and assets denominated in these currencies so paltry? A full-scale public enquiry is required to expose the inefficiencies within the SBP international market and investment department which have cost the country dearly.

SBP inefficiencies are of course not confined to foreign exchange mismanagement. In FY06 agency charges exceeded budgeted levels by 18 per cent, SDR charges by 11.5 per cent, legal charges by 36 per cent and salary related benefits in FY 06 were eight per cent higher than in FY 05 despite the fact that during FY06, 76 officials “voluntarily” left SBP, and overall employment declined by three per cent.

As we have seen during FY06 exchange rate gains fell by 70 per cent but fees paid to funds managers for producing this loss increased by four per cent. Fees paid to auditors were 30 per cent higher in FY06 than in FY05 and travelling expenses rose by 20 per cent. Miscellaneous expenses rose by over 42 per cent.

This is not a pretty picture. An inefficient and incompetent Central Bank bureaucracy headed by World Bank and ADB nominees with no previous experience of central banking and no exposure to macroeconomic or financial policy making in Pakistan is pursuing an unworkable policy.

Empirical research at PIDE, the AERC and CBM has consistently shown that the pre-conditions for effectively pursuing market based monetary policy simply do not exist in the country. Money supply is an endogenous variable. Inflation is of a cost push character. Both saving and investment are interest inelastic. The interest rate - specially the call money rate - is also an endogenous variable. The SBP plays a passive accommodative role within the system.

The impact of changes in reserve money on GDP and prices are offset by changes in M2 which neutralises the real sector impact of M0 variations.

In Pakistan changes in M2 and interest rates do not cause changes in output and price levels. The exchange rate does Granger cause changes in output and price but market based monetary policy annihilates SBP’s control over NFA flows and thus impacts negatively on its ability to control the exchange rate.

These structural characteristics cannot be wished out of existence by the incantations of the Voodoo economists because while market based monetary policy is totally ineffective in reducing inflation and stimulating growth, it is a devastatingly effective instrument for exacerbating income and asset distributional injustices and for tightening the stranglehold of foreigners over Pakistan’s financial system. Market based monetary policy must therefore be comprehensively abandoned.

We must immediately nationalise all banks and NBFCs; re-introduce strict credit planning and abolish the money market; impose strict capital controls and institute a fixed exchange rate regime; and subordinate the SBP to the Ministry of Finance and end its dependence on international money markets and IFIs.