THE State Bank of Pakistan (SBP) describes the changes in monetary stance, initiated towards the end of FY 04, as tight monetary policy. The deputy governor of the Bank has claimed that this has helped tame inflation.

The essence of the new policy is that interest rates have been gradually hiked. The SBP raised the bank rate from 7.5 in 04 to nine per cent in 05 and the rate for export refinance from 3.5 in May 04 to 7.5 per cent on July 1, 05 in several steps. For locally manufactured machinery (LMM), it was raised from 5.0 to 9.5 per cent on July 1, 05. For LMM export, the rate moved up in line with export refinance.

For long-term financing for export oriented projects, the rates which ranged from 2.8 to 4.9 per cent for maturity of 2-7.5 years, were raised to 4.0 -5.0 per cent on March 1, 05. Other interest rates thus moved up in line with new basic rates.

The weighted average of return charged by banks on their advances rose from 7.3 to 10.5 per cent in March 06 while the return on deposits moved up from 0.9 to 2.75 per cent. The rate on Treasury Bills also moved up from 2.6 to 8.29 per cent. The monetary situation is affected by the cost of credit and its availability. They are inter-related and must work in tandem. In an inflationary situation, an increase in interest rate or cost of credit will be effective, if the rate is significantly positive in real terms and expenditures are interest elastic. This works through “income “ and “substitution” effect. The former increases the cost of doing business and reduces the profit of the borrower or makes a dent in the disposable income of those leaning on consumer credit, whereas the latter makes them look for cheaper alternate sources of raising funds or use of funds. It serves as a signal by the central bank that it views the monetary expansion excessive and would soon take measures to contain or reduce the capacity of banks and other financial institutions to lend.

The manipulation of availability of credit is the most effective instrument, which in the final analysis affects the cost of credit.

The cost of credit is meaningless in an economy of the elite where the bulk of borrowing by this group is at concessionary rates, to begin with, with the possibility of making the loan non-performing for long with immunity and finally have it written off without going through any formal legal bankruptcy procedure.

The increase in interest rates in recent years has been gradual and in small doses with the result that the rates were negative in real terms until December 05. Since then, the real rate is nominal at 1.79 per cent and could not be expected to bite. The weighted average of lending rates does not indicate the actual ground reality because of wide dispersion of rates in use and the bulk at concessionary rates. The data for December, 05, pertaining return on Islamic modes of financing for the private sector, is quite revealing.

As compared with the weighted average lending rate of 10.3 per cent, bank advances at zero rate were 4.3 per cent of total advances, those at 1- 5 per cent rate were 7.6 per cent and those at 6-8 per cent rate were 10.1 per cent. This added up to 18.4 per cent of the total advances to the private sector under Islamic modes. Normally, an increase in interest is expected to discourage bank borrowing but the recent experience has been just the reverse.

Higher interest rates have encouraged bank borrowing. For instance, at nine per cent, bank advances in the above category had gone up from Rs35.5 billion in June 04 to Rs216.2 billion in December 05, while at 10 per cent they went up from Rs41.8 billion to Rs34.5 billion, at 11 per cent from Rs52.1 billion to Rs154.3 billion, at 14 per cent from Rs110.4 billion to Rs132.3 billion, at 15 per cent from Rs7.9 billion to Rs24.8 billion and at 20 per cent and above, they more than doubled from Rs15.5 billion to Rs37.5 billion.

It is very significant that while the SBP has been inducing increase in interest rates for the public, it has been actively protecting public debt by holding down the rate by simply refusing banks bids for investment at higher rates.

According to the SBP report on The State of the Economy, QII FY 06, “monetary policy remained tight throughout July-Feb FY06 while the bench mark 6-month T-bill was kept almost unchanged during this period to ensure that short- term inter- bank market rates remain close to the discount rate.” The SBP has thus injected money in an economy, which is already awash with liquidity. This is simply adding fuel to the fire.

Monetary expansion in recent years has been extraordinary and with domestic origin. Since FY 04 till May 06, the rate of monetary expansion was 32.9 per cent as compared with an increase of about 15 per cent in GDP. Domestic credit has expanded by 38.1 per cent. The Credit Plan for FY 06, based on growth rate of seven per cent and inflation at eight per cent, envisaged monetary expansion of Rs380 billion, or 12.8 per cent.

Domestic credit was to increase by Rs365 billion, or 15.7 per cent and bank borrowing for budgetary support was expected at Rs98 billion when credit to the private sector was to increase by Rs330 billion, or 13.6 per cent. As against these annual projections, during the current year till May 6, 06, monetary expansion has been Rs338.4 billion, or 11.4 per cent, with domestic credit increasing by Rs299.2 billion or 12.9 per cent, credit to the private sector by Rs345.6 billion, or by 20.2 per cent and deficit financing was of the order of Rs59.7 billion..

The SBP has played an important role in monetary expansion, its share being 38.0 per cent during June 04-March 06 and 51.1 per cent in the current year. Its contribution to total money supply in March 06 was 19.7 per cent, which is close to currency in circulation.

The central bank has been encouraging banks to lend with the result that the credit to the private sector, which the Credit Plan envisaged an increased of Rs330 billion for the whole year, rose by Rs345.6 billion as on May 6, 06; commercial bank credit rose by Rs363.6 billion as against Rs361.7 billion in the same period last year. Obviously, the SBP claim to pursue tight monetary policy and allowing private sector credit to expand with glee is working at cross-purposes.

The ratio of rate of real growth to the rate of monetary expansion in FY03 was 1:3.6 in the following year it was 1:3.1 and in the year after it was 1:2.3. During the current year, the ratio is higher at 1:1.9. As such it would be a misnomer to call resent monetary policy tight.

Inflation is not only reflected in increase in domestic prices but also has an adverse effect on the balance of payments position. Both the aspects need to be simultaneously kept in view. Balance of payments deficit siphons off the domestic purchasing power for payments abroad. Trade deficit is all the more important because it not only reduces domestic purchasing power but also adds to local availability of goods. The surplus would have the opposite price effect.

The yawning trade deficit speaks for itself. It has gone up from $0.4 billion in FY 03 to $1.3 billion in FY 05 in July-March 06 it was $6.2 billion as against $3.5 billion in the same period last year. Exports which financed 97 per cent of imports in FY 03, finance only 66 percent of imports. The overall current account has also gone into the red from a surplus of $1.8 billion FY 04 to a deficit of $1.6 billion in FY05 and was $4.4 billion in July-March 06 as against $1.2 billion in the same period last year.

The rate of monetary expansion obviously continues to be excessive. It would have been more so but for the trade deficit, which helped neutralize money supply. Otherwise, the rates of monetary expansion would have been 58.7 percent since June 04 as compared with the recorded rate of 32.9 percent. In the current year, it would have been 24.0 per cent, or more than twice the recorded rate of 11.4 per cent when the growth rate is at best expected around six per cent.

As such, it is a misnomer to call the present monetary policy as tight. It can at best be called expensive monetary policy without prospects of any success in controlling inflation so long as availability of credit is not controlled.