DR Mushtaq Khan
DR Mushtaq Khan

I must admit, I did not read State Bank of Pakistan (SBP) monetary policy statements last year.

As for the recent monetary policy decision, I anticipated the central bank to maintain interest rates at current levels — as had most of the market. However, I wondered whether the central bank could cut rates by 25 basis points — a token cut — to defuse the mounting pressure from the acute slow down in the economy.

Privately, I argued that given the growing job insecurity and unemployment, not to mention high food inflation, this is the time for damage control.

While I am not much wiser after reading the Jan 28 statement, there are interesting insights about the SBP’s thinking, which goes beyond what it intended.

The first paragraph of the monetary policy statement (MPS) gets straight to the point. It explains why inflation is on the higher side and notes that it is likely to remain elevated because of “food price shocks and potential increases in utility prices.”

From time to time, Dawn invites somebody with an important voice in an area where the economy or the business environment is facing large challenges and opportunities. Here Dr Mushtaq Khan examines the latest monetary policy statement of the State Bank of Pakistan in which it decided to maintain the policy rate at 13.25pc.

The MPS hints at a further increase in utility rates and a possible spike in food inflation from the looming sugar crisis. To ensure that the picture is not too dire, it notes that things will improve with “the recent appreciation of the exchange rate … and ongoing fiscal consolidation.”

We agree that an appreciating rupee has taken the edge off inflationary expectations, but reserve our judgement about the effectiveness of the fiscal consolidation.

This paragraph effectively admits the true determinants of inflation in Pakistan. Food and an increase in administered prices drive inflation, and yes, if the rupee is allowed to appreciate, this will certainly help deflate inflationary expectations. The fact that the entire MPS does not mention demand pressures is refreshing.

On the real sector, the SBP puts a positive spin on a pretty dismal performance by Pakistan’s manufacturing sector.

“Large scale manufacturing (LSM) indicates that economic activity is strengthening in export-oriented and import-competing industries, while inward-oriented industries continue to slowdown.”

When one looks at the data, the above-mentioned growth is at best anaemic, but the good news is that inward-looking industries are hurting.

For data covering the 5MFY20 (compared to the corresponding period last year): autos are down 37.8 per cent; electronics contracted by 16.2pc compared to 37.9pc growth in FY19; food processing is down 6.6pc against real growth of 2.6pc last year; chemicals are down by 5.5pc compared to a contraction of 1.9pc last year; and petroleum products have fallen 12.2pc compared to a contraction of 4.5pc in FY19.

Clearly, the country’s imports have fallen sharply — which helps the balance of payments but hurts the economy, yet the SBP is silent about sheer magnitude of this slump and its repercussions on jobs, consumer demand and domestic investment.

While the MPS takes pride in the improving external sector, the relevant paragraph contains some self-serving arguments. Instead of flagging the $5.9 billion fall in imports in 1HFY20, it focuses on the $529 million increase in exports.

More specifically, it highlights the increase in export volumes in rice, value-added textiles, leather products, fish and meat, claiming that this “reflects the benefits of a more competitive exchange rate and take-up of incentive credit schemes [offered by the SBP] for export-oriented sectors.”

What I hadn’t anticipated was the aggressive defense of carry trades. An entire paragraph in the MPS was used to make the following points: carry trades prove Pakistan’s credit worthiness; these inflows reduce domestic interest rates — I get the conceptual argument, but the causality is wrong; carry trades will reduce the crowding out of private sector (net private sector credit expansion this year is Rs146bn compared to Rs507bn last year, and the SBP expects credit demand to pick up at current interest rates?); shrinking external deficit has pushed up the SBP’s foreign exchange reserves, not the growing volume of carry trades; the stock of carry trades is only 3.8pc of the total market debt; this quantum (so far $2.7bn) represent ‘imited risks’; and SBP has adequate buffers “to manage any outflows in an orderly manner.”

Notwithstanding all these positives, the SBP should consider sterilising future inflows, especially if it cannot control the quantum.

Furthermore, the MPS is insensitive to the despair experienced by many Pakistanis. It highlights the spike in food inflation, predicts more potential pain on this count, hints at further hikes in utility rates, and is fine with the sharp slowdown in LSM.

Worst still, while the MPS correctly flags the reasons for the sharp increase in the cost of living, it still talks about the need to maintain positive real interest rates as the primary tool to reduce inflation. The market doesn’t buy this story, yet the SBP keeps persisting with it.

With growing pressure to cut interest rates, the SBP could become a scapegoat, with interest rates given undue importance. The point I am making is that cutting interest rates will certainly not solve the country’s economic problems, but it could defuse public anger and give the market some hope.

With supply factors driving inflation, the rupee gaining strength and a growing output gap (the unused capacity in the economy), maintaining high interest rates makes little sense.

It only adds to debt servicing pressure — which is already quite severe and continues to anger the private sector. In our view, demand compression is already acute, and the SBP should be careful not to overplay its hand.

Furthermore, in communicating its view, the central bank should speak in a language the market understands. There is a difference between talking to the market and talking at the market.

The author is former chief economic adviser at the SBP, and currently manages an advisory: www.doctoredpapers.com

Published in Dawn, February 2nd, 2020