THE assertion made in the article, captioned “Tight Monetary Policy cannot beat inflation” can be supported neither by economic theory nor practice.
When the author was college student of economics more than half a century ago, the text book equation on money was MV=PT. It stated that the money supply multiplied by velocity of circulation equals the price level multiplied by tradables. If the money supply increases along with the velocity and the tradables do not increase, the price level is bound to surge. This equation rather simplistic but as fundamental principles of economics like division of labour, economies of scale, higher investment leading to higher growth etc. are as true today as when they were enunciated by Adam Smith in 1776.
The money supply in Pakistan increased by 19.2 per cent in FY 2004 and by 18.0 per cent in FY 2043. The GDP growth in these two years was 6.4 and 5.1 per cent. Such a large differential in money supply is bound to create double digit rate of inflation after a lag. It should be emphasized that increase in money supply in one year does not immediately cause inflation but after a lag of one or two years it definitely leads to spurt in prices.
The present rate of double-digit inflation has a high component of food inflation of more than 15 per cent. The government has increased the support price of wheat from Rs300 per 40 kg to Rs400 per 40 kg during the last two years. Wheat is a staple food of all Pakistanis and the most important item in the’ food basket. Moreover, it has been observed that the wheat is the bell-wether for consumer price index (CPI) as when the prices of wheat increase, the prices of all other food items move in the same direction. The price of atta in last two years has increased by 30 per cent.
Pakistan has been receiving remittances at the level of about $4 billion per annum for the last three years. These remittances are through banking channels. It is estimated that another billion comes through expatriate visitors coming to Pakistan and other non-traditional channels. Hence, the deposits of the commercial banks receive an annual infusion of about Rs300 billion in their deposits. This excess liquidity in the economy led to sky-rocketing real estate prices, boom in the stock exchange which has recently been subsided and increase in private credit from Rs323 billion in FY 2004 to estimated Rs380 billion by the end of the current financial year (FY 2005) as the figure for April 21, 2005 was Rs363 billion.
There is no dispute among all economists that there was what is termed by the economists as the monetary overhang at the beginning of the current financial year. Unfortunately, half hearted remedial measures were taken by the SBP very late in the financial year by increasing the export finance rate as well as the discount rate in the last quarter of the financial year whereas these measures should have been taken in the first quarter of the financial year.
Similarly, low interest rates which were becoming negative after distinct and continuous rise in the CPI were allowed to continue resulting in negative real interest rate as the rate of inflation was higher than the weighted average interest rates of the banks. Hence, there was an incentive for everyone to borrow at a rate which till few months ago was lower than the rate of inflation.
The other reasons given in the article for ineffectiveness of monetary policy are (I) non-bank borrowing; (II) too much money outside the banking system in the country. Needless to say the currency in circulation forms part of M2 and it is as easy for a consumer to finance his purchase from cash money or withdrawal from the bank or ATM, hence, excessive significance should not be given to money in circulation or to non-bank borrowing which is less than 10 per cent of the total borrowing, at exorbitant rates.
Adequate supply of essential goods over a long period can not be increased by better administrative or regulatory measures. “Corruption and red tap in administrative machinery which hinder steady supply of goods should be eliminated”. It is alleged that there is too much corruption in the market committees and utility stores are inefficient.
These are peripheral issues and the columnist has not explained as to why CPI has surged from 4.6 to 10 per cent in one year when there was no sea change deterioration in the performance of market committees and utility stores. They can play a very insignificant role in the price mechanism.
What the State Bank should have done was to raise the liquidity ratio of the banks so that their scope for private credit was correspondingly reduced. Secondly, the low lending rate which is very good for investment and growth should have been appropriately raised in a sequenced manner not to jerk the market but gradually increasing the cost of borrowing in line with the sustained increase in CPI.
The government’s inability to control the cement and sugar cartels has been correctly pointed out in the article. In case of sugar if the government besides allowing imports had also released half of TCP stock of Rs 0.4 million tons as well as raise the cash margin for sugar stocks from 10 to 40 per cent, the sugar mills would have been forced to reduce their price by Rs3 to 4. In case of cement, the government need not have reduced the CED. It is interesting that whereas the cement production has increased by about 15 per cent in the current year, the 3rd quarterly report of the Revenue Division shows that the sales tax on cement constant rate of 16 per cent has declined by 12 per cent which shows serious evasion among 24 cement factories.
The cost of production of cement has gone down due to higher capacity utilization and switch over to coal fire system which has reduced their unit cost. However, the cement user is paying a higher price despite reduction in excise duty, evasion of sales tax, much high capacity utilization and lower unit cost.
The tax-to-GDP ratio in FY 2004 was 11 per cent whereas in other countries with similar per capita incomes is more than 15 per cent. This year the GDP has increased in real terms by 8.4 per cent and the tax collection so far increased in real terms by 3.5 per cent so far. Hence, the tax-to-GDP ratio has gone below 10 per cent. Moreover, GDP increase of 8.4 percent has been derived from 7.1 per cent in agriculture and 7.5 per cent in services which are not taxed at all.
This year the farm sector because of very good cotton crop and very good wheat crop with very high support price has received more than Rs100 billion which has been put in to the market without taxes and has therefore led to inflation. It is surprising that GST on ginned cotton was removed without any justification, leaving the entire agricultural processing sector untaxed.
The higher current rate of inflation in Pakistan was allowed to develop by low interest rates in order to facilitate economic growth without realizing the dangers of inflation which is extremely painful for low and fixed income groups and will eventually curtail rapid economic growth upset the external balance and eventually lead to devaluation of the rupee.
To argue that monetary and fiscal policies can not curb inflation is altogether misplaced. No one in the world thinks that the role of Allan Greenspan is advisory in the US economy, nor is the role of Governor Dr Ishrat Husain in Pakistan. Monetary policy is a very powerful tool for affecting macroeconomic indicators like inflation and along with fiscal and other policies can wrench the inflation out of the system.
(The author is a former secretary, planning)