A foggy dawn of fiscal discipline

Updated July 15, 2019

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The State Bank of Pakistan (SBP) is expected to be more autonomous by the end of the year, courtesy of the amendments made in the SBP Act. The PTI government has promised the International Monetary Fund (IMF) that parliament will approve the amendments by December.

But how would the increased autonomy affect the SBP?

This will ensure that the State Bank makes “price stability its primary objective” and “prohibit any form of direct credit to the government”. These quotes are in a document uploaded on the IMF website, after their executive board approved a $6 billion loan for Pakistan.

The government has agreed to gradually reduce its stock of borrowings from the SBP in its negotiations with the IMF

The value of the federal government’s borrowing from the SBP amounts to Rs6.453 trillion at the end of May this year from Rs3.667tr at the end of June last year, as per the State Bank. This massive government borrowing (or additional currency notes printing) over the last fiscal year has lead to high inflation in the country.

The IMF is quoted as saying, “this fiscal dominance has greatly compromised the SBP’s operational independence, jeopardising the achievement of the inflation objective.”

When excessive government borrowing from the SBP makes it difficult to control inflation, despite a tight monetary policy, the effectiveness of the policy comes into question. The State Bank believes that inflation is a monetary phenomenon and it must respond to changes in the monetary policy.

When Pakistan negotiated with the IMF regarding the loan, they had discussed the borrowing issue with them and the government had agreed to gradually reduce its stock of borrowings from the SBP. It had also agreed to convert its net stock of borrowings, which are mostly short-term treasury bills, into short-term and long-term tradable debt instruments.

While the government has stopped additional borrowing from the SBP from the start of 2019-20, the re-profiling of the existent debt may take time. The tradable debt securities can be issued in the market when the parliament approves the amendments in the SBP act.

Depending upon many factors, including banks’ liquidity requirements and maturity profile of the government debt instruments available with them, the Ministry of Finance and the SBP can decide on tenures of tradable instruments and the timing of their launch.

But this will have a significant effect on the government’s domestic debt stocks and debt servicing, interest rates structure, effectiveness of monetary policy in targeting inflation and taming inflationary expectations.

In addition to government borrowing, policymakers’ failure to record the growth of the undocumented economy had also raised inflation. If the documentation drive is successful, the government wouldn’t need to borrow domestically, instead budget financing could easily be done through commercial banks. However, if it fails, which it probably could due to growing political polarisation, it could be lead to unprecedented rise in interest rates.

Karachi Interbank Offered Rate (Kibor), the interest rate on interbank borrowing, gained 610 basis points last fiscal year and closed at 13.63 per cent. Further monetary tightening, after the IMF programme, can surely raise Kibor of all maturities.

If the amended SBP act is approved, SBP will focus more on controlling inflation than on stimulating economic growth. In other words, there will be more monetary tightening and more difficulties for the struggling private sector.

While previous governments had crossed the lawful limits of borrowing from the SBP, this government’s borrowings have been too large. As per the IMF programme the government will now have to borrow from commercial banks, which could push the interest rates even higher. And since this year’s budget is inflationary in nature, and the inflation rate is already at 9pc, it won’t take long for the rate to hit double-digit figures.

If the finance ministry and the SBP are successful in converting the government’s debts from the SBP into tradable securities, then they can also finance the budget through those securities and not only by borrowing from commercial banks.

But regardless, banks would still have to issue funds to the government and fewer funds would be available to lend to the private sector. The determining factor for the channel to issue funds to the government is the interest rates structure. The IMF and the local authorities have agreed that the interest on those tradable securities would be close to market levels. Such lucratively priced bonds would certainly attract banks.

These bonds will have maturities of one, three, five and 10 years and time will tell whether commercial banks would be interested in investing in them but it is good news for the government. The government can now at least look for non-bank borrowing sources.

Published in Dawn, The Business and Finance Weekly, July 15th, 2019