The focus of current debate in the media is efficacy of the existing monetary policy on containing the rising inflationary trend. A group of investors doing business in stock exchanges also expressed their reservations on the recent State Bank of Pakistan (SBP)s move to enhance abruptly the SBPs 3-day repo rate (discount rate) by 1.5 per to nine per cent per annum (effective from April 11, 2005).

The basis of arguments against the central bank measures is that the SBP has not been allowing the market forces to operate freely, an essence of the market based financial system. The objective of the present article is to examine the validity of these arguments.

Let us, first, analyze the tools of the market based monetary management which were intended to replace the four- decade old direct credit controlling instruments in vogue since inception of the countrys central bank in 1948.

Pursing the IMF and the World Banks prescribed financial sector reforms, the SBP and the Ministry of Finance took a number of steps jointly and severally to introduce the indirect monetary management during the 1990s gradually and in a phased manner. The first step was the public debt management (PDM) reforms started with the installation of the ‘auction of government securities (AGS)in March 1991.

The main objective of the newly-introduced AGS debts was to eliminate the wide disparity in the interest rate structure caused by government borrowings from the banking system at a fixed and much cheaper rate compared with the interest rate charged on account of private sector bank borrowings. Under the existing auction system ,the federal government is per forced to borrow from the banking system at the market determined rate of return.

The second important objective was to enhance the profitability of the scheduled banks. The commercial banks capability to transform their liabilities into earning assets was constrained due to the prevalent of direct credit control measures, the most important being the credit ceilings. Hence the commercial banks were in a way made captive market for the government to provide funds through investing in T/bills under the SLR where the yield was fixed at six per cent per annum.

The third and most dynamic objective of the PDM reforms was to pave the way for the SBP to switch over gradually to the indirect monetary management tools and do away with the frequent changes in Bank Rate, SLR and other direct credit control measures like prescribing credit ceiling/ credit deposit ratio for the individual commercial banks.

The SBP took a major step in September, 1995 to replace the credit deposit ratio as an instrument of direct credit control with the Open market Operation (OMO) supported by appropriate changes in the SLR and cash reserve ratio (CRR) and discount (3-day repo) rate.

For the convenience of the general readers the rationale of these monetary policy instruments need to be explained first. The purpose of SLR is to control the allocation of bank credit between the private sector and the public sector and not to control the overall liquidity in the system.

The monetary implication of increasing the SLR is to make available more funds at the disposal of the government through investments in government securities by the private sector. During the preceding decade, the SLR was as high as 45 per cent of total demand and time liabilities of the banks in the financial year 1992-93 when the overall budgetary deficit was as high as eight per cent of GDP.

On the contrary, the objective of making changes in CRR is to control the overall liquidity in the system. Since December, 2000 the SBP has been maintaining SLR at 15 per cent which also includes CRR at three per cent of total demand and time liabilities. The third monetary policy instrument is the discounting or the 3-day SBP repo rate.

Under the market based monetary management, the banks should not resort to discounting with the central banks as primarily they are required to promote secondary market trading in government securities to augment their day to day cash flow position.

Nonetheless, in extreme circumstances and when the SBP is satisfied that the liquidity crunch really exists and there is no lender in the inter bank money market the SBP allows the banks to get funds from the SBP repo (discounting) window at a penal rate which is slightly higher than the rate of return allowed to banks at the auction of GoP securities.

The monetary implication of discounting of GoP securities is that in the case of reverse repo with SBP, the banks offload their holdings of government securities (T-Bills/FIBs/PIBs) to the SBP and gets cash. The purchase of government securities from banks results in the shift of assets from banking sector to the SBP which technically is reflected in the increase of SBP Net Domestic Assets (NDA) which is directly related with the monetary expansion in the economy.

During the past five years, the declining trend in the SBP 3-day repo rate (from 13 in June, 1999 to 7.5 per cent in June,03) apparently showed stability in the liquidity condition in the inter bank money market which , however, does not reflect a true picture because of the fact that the SBP had to increase abruptly its repo rate by 1.5 to 9 per cent effective from April 11, 2005.

In the market-based economy, the market should not be given shock all of sudden. Instead, the SBP should indicate its intentions through the auctions of T/bills which are held regularly on a weekly basis. As regards the chief monetary policy instrument namely Open Market Operations (OMO) is concerned, the same is conducted almost by all the central banks across the world to regulate credit operation and liquidity conditions in the money market.

However, in Pakistan despite the lapse of about 10 years the SBP has not yet been able to regulate the liquidity conditions in the system effectively through the weekly OMOs. The main reason was that when the OMO started in January,1995 there was a huge monetary overhang due to governments borrowings from the SBP outside the auction. The outstanding amount of SBPs holding of MTBs created for replenishment of cash balances to the government at the last weighted average yield of T/bills auction which stood at Rs175.6 billion as on end June, 1995 increased steadily and stood at Rs508.4 billion as on end June, 2001.

However, in the subsequent three years ended June, 2004, the ministry of finance replaced those SBP holdings by retiring the costly bills and purchasing fresh MTBs when the T/bills yield ruled between 1-2 per cent per annum. The old and persistent practice of ministry of finance to borrow directly from the SBP outside the auction does not only generate inflationary trend in the economy, it has also made the market oriented auction system a laughing stock.

The primary dealers in market related government securities have serious reservations on this account. Their view point is that for development of a competitive primary market, the bidders must have correct knowledge about the cash requirements of the government in each auction as this factor has a vital bearing on bids pricing mechanism.

Unfortunately, the SBP while drawing cut-off line on the auction bid report still seems to be overwhelmingly influenced with the stance of fiscal deficit which is detrimental against the original PDM reforms of allowing a level playing field to all bidders in auction.

It can be deduced that the lower interest rate regime during the preceding three years in the country was more beneficial to the government than the scheduled banks whose investment income on government securities has reportedly declined. To compensate their losses in profit on account of investment income, the commercial banks particularly foreign bank branches diverted their surplus liquidity towards consumer financing.

The availability of liberal bank loans under consumer financing for acquiring luxurious imported durables by lower middle class has further exerted pressure on the inflationary trend.

In conclusion, it may be stated that in near future there seems to be no silver lining on the horizon which could make the common man to believe that the government is really concerned with the rising inflationary trend.

No doubt, the present budget (2005-06) is intended to improve the supply side of the economy through a number of investment-led incentives, nonetheless, the widening trade and current account deficits pose a great threat to the rupee. An adjustment in the present exchange rate vis-‘-vis dollar may lead to increase the export receipts in rupee terms and resultantly may bring down the trade deficit level to that extent.

Simultaneously, the intended devaluation will also increase the rupee value of imports which may offset the benefits accruable through devaluation of the rupee.

The government should also radically improve its tax collection machinery to minimize the impact of excess demand on the economy. As regards the efficacy of the monetary policy in regulating the excess demand condition in the economy is concerned, that can happen only when the central banks monetary policy ceases to be subservient to the governments fiscal policy.