As Pakistan is expected to get a new financing line from the IMF, a few challenges have emerged on the monetary front.

The challenges relate to independent monetary policy formulation, and making the policy supportive of economic growth while being equally responsive to inflationary pressures.

Sources privy to recent talks between Pakistani policymakers and the IMF mission say that the Fund is not for or against a specific stance on monetary policy, and that no such thing is a pre-condition to the approval of the new $5.3 billion Extended Fund Facility.

“What they have asked for relates to expansion in NDA and NFA (net domestic assets and net foreign assets),” one of the participants of the Pakistan-IMF talks in Islamabad told Dawn.

“Some quarters are speculating that the IMF wants tightening of the monetary policy, as they think that in our effort to keep the expansion in NDA at a certain level, we’ll have to do it. But we have other options.”

Actually, when the IMF staff members conduct discussions with a borrowing country on a lending programme, both sides agree upon projections of some key economic indicators. CPI inflation is one of them.

And since growth in NDA and NFA affect reserve money growth, which has a direct bearing on inflation, the two sides also project growth rates of NDA and NFA. “The purpose is to make sure that inflation and economic growth numbers, as projected for the agreed period, are not disturbed,” says another participant of the negotiations on the new IMF loan.

But then it is up to the central bank’s independent board of directors to decide the course of monetary policy, keeping in mind how their decision would impact the projections of NDA, NFA, reserve money, inflation and GDP growth etc.

It is wrong to assume that every time a central bank is faced with the task of keeping NDA expansion in check, the only option it has is to tighten monetary policy. It is true that in our case, NDA has been expanding faster due to government borrowing from the banking system. It is also true that NFA growth, which remained negative in FY13 in the absence of net generous inflows of foreign exchange, may turn positive after a new IMF loan is obtained, and after our external sector starts performing better.

Presumably the twin developments (high growth in NDA and possibility of pickup in NFA expansion) will accelerate reserve money growth, which, in turn, will create added inflationary pressure.

But then, inflows through the IMF, and anticipated improvement in the external sector (signs of which have already become visible after a turnaround in FDI), will reduce the need for government borrowing from the State Bank of Pakistan (SBP). This would serve as the first line of defence against inflationary pressure.

“In that case, the SBP may keep its policy rate unchanged, or even reduce it, rather than tightening monetary policy, if some other supportive factors also become available,” explains another source privy to the IMF discussions.

Central bankers say that if Pakistan succeeds in securing a new financing line from the IMF, the Fund staff will keep an eye over how the SBP conducts its periodical open market operations.

In the recent past, the SBP had made it a practice to pump extra liquidity into the market ahead of the auction of government securities to ensure full participation of banks. Now, liquidity injections before the auction of government treasury bills and bonds cannot be solely dictated by borrowing requirements of the government. Open market operations have traditionally been used to steer monetary expansion, and the SBP can again use them for this purpose without necessarily tightening its key policy rate.

Central bankers also point out that the introduction of the facility for banks to deposit overnight excess funds with the SBP back in 2009 greatly helped in the execution of monetary policy. They recall that in February this year, the central bank had increased the rate of return on such excess funds placement by 50 basis points to seven per cent, even though it had kept its own overnight lending rate for banks unchanged at 9.5 per cent.

“In other words, the SBP had encouraged banks to keep themselves efficiently liquid, i.e. get a higher return if your end-of-the-day liquidity is genuinely excessive, but at the same time be prepared to pay what you were already paying to the SBP if you go short of liquidity and borrow from us,” explains a SBP official.

“The reverse of it can happen if the central bank decides to squeeze banks’ liquidity, i.e. it can again keep its own overnight lending rate unchanged and lower the rate it is offering to banks that park their extra liquidity at SBP. Besides, changing cash reserve ratio and statutory liquidity ratio are always an option to set direction of the monetary policy.”

Since a policy rate change does impact exchange rates in one way or the other, and as a central bank also has to see the balance of payments position of the country before changing its monetary policy stance, an expected IMF loan would have important ramifications in this regard.

“The pressure on the rupee would be lesser than what it is today. Or in the best case scenario, i.e. an IMF loan accompanied by improved export earnings, continued growth in remittances and faster inflows of FDI, the rupee can even regain part of the losses it has suffered so far. In that case, if the SBP makes any move to ensure a fairer return to rupee-based depositors by squeezing banks’ excess liquidity, it won’t have to worry about a draw-down on banks’ foreign currency deposits that make part of our overall liquid foreign exchange reserves,” elaborated the SBP official.

Bankers and central bankers privately say that entering into an IMF loan programme means the nominal/real effective exchange rates will come under the spotlight during periodical reviews of the loan programme between Pakistan and the IMF. This is where the central bank will have to tread carefully, because “the IMF will raise questions about any market intervention beyond those aimed at smoothening out temporary exchange rates volatility,” warns a foreign banker.

But after managing exchange rates through a number of tools, including market interventions, in the last three years when there were no inflows from the IMF, the SBP has become more adroit in handling temporary speculative attacks on the rupee. “And, once the IMF lending starts, speculations against the rupee would even otherwise lose steam,” argues the chief foreign exchange dealer of a foreign bank.