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Monetary and fiscal coordination

June 03, 2013

WITH the monetary policy review due this month, market expectations are that the central bank may announce another cut in the policy rate.

The State Bank of Pakistan had last reduced its benchmark interest rate by half a percentage point to 9.5 per cent in December 2012, and has since maintained it at this level.

The expectation of a rate cut has also prompted by PML-N’s stance of making landing rates ‘conducive for borrowers’.

As the new government presents the FY14 budget in a few days from now, observers will keenly watch the measures it takes to increase the tax-to-GDP ratio, which is currently below nine per cent. It would be ideal if the tax revenue base is broadened and current expenses are curtailed to squeeze the fiscal imbalance. But if this happens, and monetary easing continues in June, then the cumulative impact of the two sets of policies would be positive on economic growth.

And therefore, Prime Minister-elect Mr Nawaz Sharif needs effective fiscal and monetary coordination, as he has pledged to turn around the economy as soon as possible — amidst a severe energy crisis.

“The new government will have to stick to the limits that the fiscal responsibility law imposes on it, and the central bank will have to deal with fiscal authorities in a truly professional manner,” says a senior State Bank of Pakistan (SBP) official. “Without this, the dream of turning around the economy, accelerating the growth rate, revitalising the external sector, and re-energising state-owned enterprises (SOEs) cannot materialise.”

The fiscal responsibility law requires the government to bring its quarterly borrowing from the central bank at zero by the end of that quarter. During the previous government, not only was this law violated, but the government had also been taking big loans from banks or rolling over previous ones. This continued to crowd out the private sector.

But as private sector businesses are now getting larger bank credit (Rs160 billion between July-April 2013 against Rs57 billion in July-April 2012), the government’s tendency to borrow heavily from both SBP and commercial banks is far from over.

From July 1, 2012 to May 17, 2013, the federal government borrowed Rs413 billion from the SBP (against Rs391 billion in the same period of FY12), and its borrowing from commercial banks exceeded Rs751 billion (against Rs684 billion in the year-ago period).

As the new government prepares the budget for the upcoming financial year, what looks more likely is that it will try to increase both tax and non-tax revenues and also contain non-development expenditure.

For this, the government will need to take a number of steps: revenue collection has to be made more efficient; borrowing through National Saving Schemes must be raised further, and aggressive marketing of treasury bills among individuals and companies must be ensured.

Reinvigoration of state-owned enterprises will initially require some financial bailouts. The government will also have to allow them to make investments to improve their production and efficiency.

So, in order to let businesses continue healthy levels of borrowing and to provide an enabling environment to SOEs, the structure of interest rates needs to change by easing of monetary policy.

Similarly, the government’s internal debt policy also has a lot to do with monetary policy. For some years, the government (and not the central bank) has been deciding the cut-off yields on treasury bills. In exercising this right, the government’s debt office keeps in view the demand for T-bills, liquidity in the banking system, and the government’s borrowing requirements.

During the tenure of the last elected government, the SBP used to make frequent liquidity injections into the banking system ahead of T-bill auctions. Whereas this practice ensured that the government borrowed the required amount of money at desired rates, it was also based on the premise that private sector credit demand was low, and that if banks were not provided an opportunity to invest heavily in government debt papers, their profitability would be hit.

And therefore, if the central bank now stops injecting huge amounts of liquidity into the banking system, it would dissuade the government from borrowing too much from banks. On the one hand, it would help achieve some fiscal discipline. But on the other, it will make government debt costlier, thus increasing the cost of internal debt servicing, and in turn, creating fiscal pressure.

“So the central bank will now have to make difficult trade-offs as far as unusual liquidity injections are concerned,” says the treasurer of a local commercial bank.

Monetary policy’s key purpose is to control monetary expansion and keep inflation at the desired level, but at the same time, also see that policy decisions are supportive of economic growth. Interest and exchange rate structures, private sector credit, savings and investment, can be, and are, influenced by the changes in monetary policy.  Fiscal and monetary coordination is said work if monetary policy helps meet the broad economic objectives that the fiscal policy is striving to achieve.

Currently, Pakistan’s large fiscal imbalance (amid growing circular debt and with no borrowing from international financial institutions) demands a tight fiscal policy, which promotes austerity in non-development expenses and boosting of tax revenues. It also calls for an internal debt policy that supports the generation of non-bank borrowings, but not at the cost of distorting the overall interest rate structure.