ON July 21, SBP announced the monetary policy for the July – December period. According to market analysts, while the emphasis this time is on fighting inflation and bringing it down to a reasonable level “during the next six months”, a meaningful expression used by policy-makers is ‘tightened monetary expansion’ which conveys the impression that while monetary expansion will not be contained, resource flow would be guided to fulfill certain objectives that the SBP considers important.

This policy approach is positive though it has been adopted a little late in the day. Analysts had recommended it a while ago pointing to the fact that some players in Pakistan’s financial services sector were acting merely as intermediaries diluting their immensely important role of giving business and industry a sense of direction by prioritizing investment in sectors that will promote growth on a sustainable basis. The monetary policy stance suggests that SBP now proposes to mend the ways of such players but the policy is still too soft on monetary management measures, which reflects over confidence in the good intentions of market players.

It appears that taking this stance became necessary because rapid de-regulation of financial services since 2000 coincided with an unprecedented surge in liquidity and financial institutions demonstrated a zeal for channelling savings into marginally productive venues for short-term gains. Much to the dismay of free market lovers, these trends once again seem to be turning over to the state the responsibility of pursuing socially acceptable goals. The contours of the forthcoming SBP Annual Credit Plan will disclose the extent to which this turns out to be the case.

The expanding gulf between credit expansion and GDP growth was signalling a cavalier attitude to governance in the financial services sector. The trend fore-shadowed the creation of imbalances in many economic sectors from where resources couldn’t be retrieved without banks incurring substantial losses. Avoiding such consequences required rationalizing the marketing effort instead of being driven by market forces for short-term gains. Prudence of this sort was not witnessed in the profile of marketing. An example thereof was that rise in consumer finance (93 per cent) in 04-05 accounted for the second largest chunk (Rs80 billion) of the total fresh credit extension of Rs390 billion.

The emphatic reference to containing inflation indicates that the financial services sector has not been doing its job as responsibly as it can. In Pakistan businesses tend to be highly leveraged. As provider of financial resources, this sector could influence pricing mechanisms if it remained committed to maintaining economic stability. Banks, on the other hand, were less than judicious in credit expansion, which broke all previous records. It allowed prices to rise on the average by 5.28 per cent and in spite of depreciation of the rupee by 3.28 per cent the industry had to absorb a loss of 2 per cent in its external competitiveness.

Coming at a time when SBP is not sure about the extent to which rising balance of payment deficit would be off-set by inward foreign remittances, the development doesn’t pump up confidence in sustainability of the growth pattern of the past three years given the hefty 40 per cent rise in imports, of which a large part was accounted for by imports of cheap consumer goods that hurt domestic industries. On top of this comes the revelation that government spent nearly Rs80 billion on subsidizing the rise in oil price – a trend that is unlikely to change, at least not in 05-06.

The government plans to substantially increase its budgetary outlay which, in all probability, will result in higher than targeted public sector borrowing. This implies preservation of resources for fiscal support. The other indication of this possibility comes from the recent SBP announcement that banks should gear up for providing up to 20-year financing for infrastructure projects. Although there has been no comment this subject by the banking sector yet, it is clear that the government and SBP now want banks to take their developmental role seriously.

Quiet understandably therefore, the policy stance wants the financial services sector to make qualitative judgments about longer-term consequences of loaning, which requires focusing not merely on their nominal returns, but on the implied social returns as well that have implications for the society as a whole – a reminder to the financial services sector that in a de-regulated environment extending financial services amounts to more than a number game.

The policy stance suggests that SBP wants banks to focus on specific sectors and activities, which have been hinted at. Therefore in 05-06, the preferred SBP focus of credit expansion will be SME and agricultural sectors, capacity expansion by industries with the potential for import substitution, and BMR initiatives by industries that consume indigenous raw materials. Credit supply to remainder of the economy will be tightened. How SBP proposes to go about ensuring credit expansion along these lines will, hopefully, be spelled out in the Annual Credit Plan.

Regarding interest rates, the indication is that “extent of interest rate changes will be determined by the magnitude, direction and speed of inflationary pressures” and “would remain tight until inflationary pressures are reasonably eased off”. This stance signals a slow but consistent rise in rates, and if that doesn’t work, banks could be saddled with higher statutory reserves to mop up liquidity that is fuelling inflation. But in the absence of inflation and money supply figures that could trigger one or both these remedial actions, predicting a rate trend would be guess work.

Nevertheless, in view of the stated bias of the monetary policy, rise in core inflation may induce SBP to hike up T-Bill cut-off yields at every auction across all tenors, possibly by a quarter percent each time. These hikes will add to the pressure for hiking up the Discount Rate, which will then be built into loan rates charged by the financial services sector as a whole. This chain reaction seems to have been activated because the money market reacted swiftly and 6-month KIBOR – the rate preferred by most banks for pegging their lending rates – shot up to 9 per cent. This is also a signal that banks would jack up lending rates rather than be saddled with higher statutory reserves.

The policy stance has implications for the borrower community as a whole. Businesses used to availing credit at the lowest ever rates seen in our history will find their profitability squeezed. It should remind them of two basic truths: businesses can’t remain under-capitalized, and should depend on cutting waste and economizing on resource use – something they were beginning to overlook. The export sector will need to tighten its belt pretty hard because SBP can now afford only minor adjustments in the rupee’s exchange rate to prop up their external competitiveness.

It should cause a bigger stir among those who borrowed on floating rates because their borrowing cost could rise steadily. The hardest hit will be consumers with large auto loans on floating rates because their repayment capacity (represented by disposable income) will be squeezed by at least two negative trends: rising fuel cost and CPI. This borrower segment is also the weakest for the banks to retrieve their funds from without suffering losses, and should be as much a cause of worry for the banks that now have large portfolios of consumer credit.

Consumer credit, if extended too easily, goes far beyond the objective of increasing consumption to allow for fuller utilization of industrial capacity and cost cutting. It fosters a culture of living beyond means and disdain for saving. According to latest Fed figures, saving by Americans has fallen to just half a percent of their disposable incomes. Such indiscretion is, at least for the moment, affordable by the Americans because almost every Central Bank keeps investing in US securities to fund this indiscretion. Amazing it may be, but that is the harsh reality.

Pakistan finds it hard to attract even minor chunks of foreign investment (remember the KESC fiasco?). Given the problems with our image (for once admitted by the PM) we will eventually survive on our domestic savings. Anyone, including the SBP, who thinks otherwise, is making a serious miscalculation. What we need is a culture of saving and investing in our falling physical and social infrastructure. Short of that, we can’t build a prosperous Pakistan no matter what politicians (and bureaucrats with vested interest) might talk you into believing in their TV interviews.

The lesson for everyone is that in de-regulated markets cost of borrowing can fluctuate, and shouldn’t be relied upon as a permanent source for sustaining businesses. That resource availability cannot be guaranteed unless savers are paid fair returns to encourage larger saving. What remains to be seen is how the SBP enforces upon all concerned the acceptance of these realities. In the past SBP didn’t use its muscle to do so. But, so far, developments during 2005 don’t leave too many soft choices with the SBP. The system needs to be woken up to these realities.