The central bank’s monetary policy for the first half of FY 08-09 is a muted response to the challenges the economy confronts. Why, after listing all them in detail, the policy stance rests only on a controversial one per cent hike in the discount rate, is a mystery. Did the unfair criticism of recent SBP actions prompt this response?

It is true that businesses unfairly downgrade the impact of external factors and their own inefficiencies while pinning the blame for their sliding competitiveness on mark-up rates although, of their total costs, mark-up constitutes a very low proportion. Besides, compared to inflation, mark-up rates are still lower. But not exercising the options the SBP had to contain money supply is odd.

SBP rightly worries about inflation-fuelling monetary expansion that the ballooning fiscal deficit is forcing it to undertake. It rightly questions the budgetary assumptions such a 6.4 per cent rise in public expenditure when the track record suggests a far higher rise, or a 24 per cent rise in tax revenue when the track record foretells a rise of only 13 to 14 per cent; with lower GDP growth it could be even lower.

In FY 07-08 government borrowing set a new record; it crossed Rs688 billion defying any chance of repayment in one financial year. SBP had therefore recommended its gradual retirement – a meagre Rs21 billion per quarter. But, in July alone it went up by Rs32.9 billion because expenditure far exceeded revenue collection, and chances of balancing the two in near future are not very bright.

This trend was triggered by the federal budget FY 08-09 that didn’t adequately tax the sectors with a potential for it. The paltry 10 per cent rise in import duty on cars with larger than 1800cc engines, Rs500 on mobile phones, maximum 20 per cent income tax on annual salary slab for Rs8.65 million and above, and taxes levied on real estate defy any explanation except their being rich-friendly.

A small hike in tax rates applicable to the financial services, cement and mobile phone sectors was in order given the steady rise in their earnings. Surely, it would not have dented their dividend payouts. Instead, it could have lifted their image as socially responsible sectors ready to share more of the government’s burden but neither the government nor the sector players saw the need.

Rational taxation based on such logic could have given the government the credibility it yearns for, and shown its commitment to fiscal responsibility in fairer re-distribution of national wealth. So far, it has opted only to borrow (rather than tax) and spend, turning the Fiscal Responsibility Act into a bad joke.

Bulk of the government borrowing is funding current expenditure that fuels consumption and inflation although, according to SBP, growth in real demand during FY 08-09 rose by 7.1 per cent compared to real supply growth of 5.8 per cent. Yet, the budget avoided tough measures to contain imports and the trade deficit, which will weaken the rupee posing a very tough challenge to the reserve-strapped SBP. Escalating trade gap is expanding the current account deficit and fuelling inflation to an unsustainable level. SBP has finally admitted the oft highlighted fact that discount rate hikes alone won’t contain inflation because SBP can influence money and credit flows only in the documented sectors; bulk of the economy is beyond its reach.

Also, that food inflation can be contained only by administrative action that reverses hoarding-triggered supply shortages. The report rightly warns that if this distortion is not removed, economy-wide demand for higher wages could further blunt the competitiveness of the industrial sector and price Pakistan’s exports out of the world markets.

Trade and current account deficits have harmed the perception about Pakistan’s risk encouraging lenders to demand baffling returns (6.5 per cent over LIBOR). This limits the options for beefing up exchange reserves that are depleting at $1.6 billion a month. In recent weeks,the only significant inflow was a budgetary support loan of $500 million from China.

On his maiden visit to the US, the immediate relief the PM could obtain was $115 million for food import. The other $15 billion inflow be over a decade and thus won’t immediately boost the falling exchange reserves. The Saudi $5.9 billion deferred payment facility on oil imports is still ‘under discussion.’ Uncertainties created by weak fiscal management may also discourage inflows from friendly Middle Eastern states into Pakistan’s agriculture sector.

In spite thereof, the government doesn’t realise that public expenditure must be funded largely by tax revenue and partly by borrowing from banks and the public; SBP should be its ‘lender of last resort.’ Given this scenario, instead of giving up, SBP must press the government to (a) float 3 and 5-year bonds to raise money from institutional investors, (b) strengthen the service delivery capacity of infrastructure-wise handicapped NSS network, and (c) cut its current expenditure.

In the interim period while government borrowing is shifted to other sources, SBP must suck in rupee liquidity to contain inflation and the slide of the rupee. Raising the discount rate – a bad option – pushes up lending rates and hurts industrial competitiveness. Instead, SBP should have increased SLR that sucks liquidity but offers banks a return on investment therein; with a two per cent hike it could have sucked in about Rs40 billion.

SBP should cut its funding of export finance by raising banks’ share therein to 40 per cent or higher. For banks to accept the additional burden it may be expedient to raise their share in the subsidised mark-up; one per cent hike therein, would cost SBP only Rs2.5 billion but the move could suck in another Rs25 billion.

With a weaker risk rating, Pakistan can attract FCY bank deposits (needed to boost its depleting exchange reserves) only at a premium. Fractionally subsidising the profit paid on FCY deposits to permit banks to accept them at 0.75 to one per cent over LIBOR (far less than the 6.5 per cent demanded by institutional lenders) is an option that yielded good results in the past. It is time to adopt a multi-dimensional approach to plugging the gaps, not for muted responses that render this task more unmanageable with the passage of each day.