Since the government borrowing from the central bank is inflationary, the PTI government “will no longer utilise this facility from July 1, 2019,” State Minister for Revenue Hammad Azhar announced in his budget speech on June 11.
He also said that the government’s medium-term inflation target “will be in the range of 5-7pc.” The twin announcements are important.
If the government is not going to borrow from the State Bank of Pakistan (SBP) from the next fiscal year, will it be borrowing excessively from commercial banks? If the answer is yes, then it is good news for banks but bad for the private sector as it will be crowded out. Azhar did not say whether the government will let the stock of its borrowing from the central bank where it is now or will it bring it down.
But in the past both Zardari’s and Nawaz Sharif’s governments have been switching over from central bank to commercial bank borrowing and vice versa. And, both conveniently crossed the limits set for borrowing from the banking system. Excessive government borrowings deteriorated banks’ advances to deposit ratio to the extent that the central bank had to warn them that by parking the bulk of their deposits in government debt securities instead of lending to the private sector they were indulging in financial disintermediation.
When PTI came into power its policymakers thought it feasible to borrow more from the SBP and less from banks. The problem arose when loan negotiations started with the IMF.
The IMF staff reminded our policymakers of their obligation towards Pakistan’s Fiscal Responsibility and Debt Limitation Act of 2005 that sets limits for the government borrowing for fixing fiscal deficit. Now as we have signed a $6bn loan agreement with the IMF and are waiting for final approval of the deal by the Fund’s board of directors, policymakers in Islamabad are taking some steps agreed upon with the global lender. One of them is giving greater autonomy to SBP and another is for the government to switch over to Treasury Single Account to be maintained with the SBP. The state minister, in his budget speech mentioned about both.
A more autonomous SBP being sole custodian of the treasury’s single account would be able to help the government of the day keep its fiscal house clean and transparent. Beyond that, a more autonomous central bank will also be able to make inflation the anchor of its monetary policy instead of pursuing twin objectives of promoting economic growth and keeping inflation under check. When Azhar mentioned about his government’s plan to target inflation at 5-7pc he rather unintentionally dropped a hint that sometime in future inflation targeting could be the anchor of our monetary policy, if the fiscal and monetary authorities so decide. “Fighting inflation will be paramount for us,” the minister announced in budget speech “We will tailor our fiscal and monetary policies, coordinate with the provinces and adopt administrative measures to fight this menace,” he further said before promising that the government will stop borrowing from SBP from July 1.
The time is ideal for this purpose. In less than 11 months of FY19 (up to May 24), the federal government’s net incremental borrowing from SBP stood at Rs2.454 trillion. One reason for this huge and quite inflationary borrowing was that the government was using part of it to retire commercial banks’ credit.
During this period, the federal government managed to retire Rs1.14tr worth of banks’ credit on a net basis. So, if it stops borrowing from SBP in the next fiscal year it will have enough room to borrow from commercial banks without crowding out the private sector. The government has set bank borrowing target of Rs339bn for FY20, far lower than the FY19 revised estimate of borrowings of Rs1.356bn. One of the reasons for setting such a modest bank borrowing target for FY20 is that the government has not only set a very ambitious revenue target but also expects larger inflows of non-tax revenue.
But will the proposed switching over to borrowing from commercial banks help check inflation? Theoretically yes. Borrowing from the central bank essentially means printing of fresh currency notes which increases the rupee supply. That results in too much money chasing too few goods and causes demand-pull inflation. A reversal of the practice should, therefore, contain inflation.
Since we also have a large informal economy and the latest efforts to document it via asset declaration scheme and other measures may take some time to produce results.
But in our current situation it’s not just too much money chasing too few goods that is causing inflation. Currently inflation is also rising in the country partly due to higher cost of production after the rupee depreciation and partly due costlier finance for industries and businesses following interest rate tightening. In FY19, SBP’s target policy rate has gone up by 5.75pc to 12.25pc affecting the entire interest rate structure and up till June 13 the rupee has lost around 26pc value against the US dollar in the interbank market.
So, even if the government stops borrowing from SBP from July 1, we should not expect inflation coming down automatically as the lagged impact of rupee depreciation and higher interest rates would continue to push up the cost of all goods and services. And, if the rupee depreciates further due to external sector weaknesses and as per the IMF demand that still regards it overvalued checking inflation would become more difficult even through further monetary tightening.
The federal budget itself is inflationary in nature as additional taxes are sure to push the cost of production of goods and services. The tax revenue collection target of Rs5.5tr is also too big and slippage in it could expand FY20 fiscal deficit target to a level requiring the government to fix it with higher-than-projected reliance on external resources.
So, the country may continue facing twin deficit for quite some time keeping the rupee under pressure. Besides, what makes chances of inflation remaining high in FY20 is growing conflict between US and Iran and between Iran and Saudi Arabia. That is already pushing fuel oil prices up and may continue keep these prices under pressure until all sides show meaningful restraint.
Published in Dawn, The Business and Finance Weekly, June 17th, 2019