Tracking actual reasons of inflation is tricky, if not treacherous. In Pakistan, it’s trickier because of scant data on market behaviour, and the absence of segmented information on household expenditure preferences.
“Price-setting by companies is also not based upon real time information, which makes matters worse,” says a central banker, quoting a 2011 study which shows that 71 per cent of manufacturers in the country use backward-looking information while setting prices. This leads to high ‘inflation persistence’ or a tendency in prices to remain high even when other factors push prices downwards.
The study shows that this is particularly true in the case of non-food, non-energy core inflation, and makes a steady transmission of monetary signals difficult.
Central bankers say this can be checked if companies have forward-looking or real time information on the dynamics of inflation.
For the last three years, the State Bank of Pakistan (SBP) has been reviewing monetary policy stance after every two months — and not on a six-monthly basis — giving firms a chance to build up real time or forward-looking inflation outlook while setting prices. A small number of them, including multinationals, do it. But a majority of firms are lagging behind.
But does the inability of firms to set prices based on closer-to-reality inflation outlook give rise to inflation if their price-setting decisions, based on backward-looking information, calls for a reduction in prices?
“Theoretically, it cannot,” responds a senior central banker. “But if their price-setting is not realistic, it actually makes transmission of monetary signals a bit difficult, thus mitigating the impact of monetary easing when the central bank tries to tame inflation through lower interest rates.” That explains, at least partly, why inflationary pressures keep showing up even during the cycle of stable-to-low interest rate policy.
Another pertinent moot point in inflation dynamics is whether excessive government borrowing from the banking system always pushes up inflation.
“Government borrowing from the central bank, almost a byword for note printing, does this,” says an official of the ministry of finance. But government borrowing from commercial banks is not much inflationary when a part of this borrowing is used to finance subsidies on energy, provide tax exemptions to priority productive sectors, undertake development projects or facilitate pro-poor spending.
“Because in such situations, government borrowing indirectly boosts supplies, energises domestic economic demand and contains the spread of currency in circulation,” explains the treasurer of a large local bank. “Persistently large currency-in-circulation and high inflationary expectations, spread by mass media, are also key drivers of inflation.”
In FY08 and FY09, when inflation was at 21.5 per cent and 20.8 per cent respectively, it was not just the result of monetary expansion caused by big government borrowing from the banking system. Supply constraints due to the impact of the global recession on our manufacturing and markets also played a key role. But from FY10 to FY12, we see additional things, like devastating floods and additional government and private sector spending on flood relief and rehabilitation and a gradual rise in domestic demand, which kept inflation above 10 per cent.
However, increased domestic demand for industrial goods and monetary easing led to a strong revival of large-scale manufacturing in FY13, and improved post-flood showing of the agriculture sector brought inflation down to 7.4 per cent.
A peculiar aspect of very high inflation in FY08 and FY09 was that banks had almost stopped fresh lending to the private sector to avoid a buildup of bad loans because of the anticipated poor performance of companies following the global financial crisis and the recession. But this also meant a near-absence of one component of overall supply. So, was it just excessive government borrowing that continued to expand money supply?
“Not exactly. A buildup in net foreign assets (as a result of coalition support fund and IMF loan) also had an impact on M2 (broad money) and reserve money,” suggests the treasurer of a leading commercial bank.
Senior bankers admit that banks have not been lending generously to private sector businesses (PSBs) for the last few years. But they dispel the impression that private sector lending has come to a halt, and point out that credit off-take and retirement cycle is now more driven by interest rate considerations of firms rather than by seasonality of cash flows.
For example, in 11 months of FY13, total net credit disbursement to private sector businesses stood at Rs83 billion, but a huge retirement of Rs66 billion in June reduced overall credit flow to PSBs in FY13 to Rs17 billion. Credit supply to the overall private sector, including non-bank financial institutions (NBFIs) turned negative by Rs19 billion, but bankers say that this happened as banks withdrew their funds from NBFIs to invest in the booming stock market, particularly in the last quarter.
“It’s not the amount of credit retirement by private sector (Rs66 billion in June) that is noteworthy. What is more important is that it represents about 80 per cent of the total credit flow in the previous 11 months (from July 2012 to May 2013),” points out a local bank treasurer.
“I guess firms were too sure of a policy rate cut (which eventually materialised on June 24 when the SBP lowered its reverse repo rate from 9.5 to nine per cent), and they repaid expensive loans. Larger corporate profits in the third quarter and in the first two months of the fourth quarter (of FY13) also made loan repayment quite easier.”
Higher cost of imported goods, whether due to unusually big depreciation of the local currency or because of increase in insurance and freight charges or as a result of rising inflation in the supplier’s country also influence inflation numbers. This ‘imported inflation’ also had a hand in pushing up the price-line in the last few years. For example, a massive 20.3 per cent chopping of the rupee value against the dollar in FY09, after the global recession, was one of the key factors behind the 20 per cent plus inflation here.
“Similarly, a big 21.5 per cent inflation in the country in FY08 had already created the environment for the rupee to shed so much of its weight in FY09,” remarks a banker-turned-business tycoon with interest in the food and cement sectors. “That’s why you see that despite a very high inflation in FY09, the rupee’s slide in the next year was below seven per cent. The reason is that a complete business cycle is normally spread over from one year to three years, and changes on the interest rate and forex rate front are absorbed or passed on in price-setting by firms periodically and often in installments.