INFLATION is causing concern to every one and the Government has avowed to control it. The concern about inflation has been heightened by an abnormal increase in domestic prices during FY04-05 when consumer prices, measured by the Consumer Price Index (CPI), doubled to 9.3 from 4.6 per cent in the preceding year. During July=September 05, the rate was 8.65 per cent.
The CPI does not capture the prices of all commodities and some of those excluded may be important users of bank credit, like automobiles, motorcycles, and the whole host of consumer durables. Similarly, prices of assets like real estate and scripts dealt at the stock exchange are important omissions.
Inflation manifests itself not only in domestic prices, but also has an important impact on the balance of payments position, particularly the trade balance. As a corollary, the exchange rate is also affected. As such, the behaviour of both the indicators must be kept in view. It is significant that during FY04-05, the trade deficit (on FOB basis) jumped to $4.5 billion from $1.3 billion in the previous year.
The current account of the balance of payments, which had been in unusual surplus for some years, was converted from a surplus of $1.8 billion in FY04 to a deficit of $1.5 billion-a deterioration of $3.3 billion in one year. At the same time, Pakistan rupee vis-à-vis the dollar depreciated by 2.6 per cent as against 0.5 per cent in the previous year.
During July-August 05, the trade deficit was at $1.3 billion as against $0.55 billion in the same period last year while the current account deficit was at $1.24 billion, up from only $4 million.
Inflation is a very complex phenomenon and cannot be explained by any one factor alone, particularly by mere changes in the growth rate. Economic managers of the country attribute inflation during FY05 to the record growth rate. This view is not supported by objective economic analysis. If anything, other factors remaining the same, the effect should just be the reverse, as increased output of goods and services, their demand remaining unchanged, should bring down their prices. The official approach totally ignores the demand side.
According to Economic Advisor of the State Bank (Dawn-EBR, Sept. 5, 05), “A quantitative study on determinants of inflation in Pakistan shows that ‘One per cent permanent increase in real output decreases the CPI by 0.71 percent and the GDP deflator by one per cent after a lag of one year.’ In this way, the fruits of monetary policy followed in the last couple of years would continue to be felt in coming years.”
Inflation, apart from the growth rate, may be ‘cost push’ or ‘demand pull’ or a combination of both. The former indicates the impact of increase in input prices, which may be for domestic or international factors, like increase in utility prices or international petrol prices, which are controlled and changed by the government as an administrative and political decision, often with a time lag...
International prices affect Pakistan in a significant measure, as it is an exposed economy, its foreign trade alone accounting for more than one third of GDP. The “demand pull” inflation reflects increased demand for goods and services, which may be due to increase in international demand for exportable goods, or domestic absorption.
The latter, in turn, is determined by the rate of population growth and changes in purchasing power of the people, both in terms of magnitude and the way it is used-saved or used to incur expenditure for consumption as well as investment. Investment boom can heat up the economy.
In Pakistan, important factors bearing on purchasing power of the public are inflow of foreign capital, mainly remittances by Pakistanis abroad, and bank credit. At times, there may be supply shocks due to natural factors, like weather and disaster. In the whole process, the psychological factor of expectations, which may not always be rational, is no less important. This will be determined more by personal experience and perception than official pronouncements of good days ahead.
Fiscal policy is to continue to be expansionary, the extent of which is actually known post facto. Budgetary calculations for FY05-06 are going to be upset by the unprecedented earthquake whose full toll is not yet known. The main burden of adjustment, therefore, falls on monetary policy.
In this connection, it must be remembered that in Pakistan the effectiveness of monetary policy is constrained by large currency in circulation, ready cash in public hands, which accounts for about one fourth of total money supply (22.5 per cent in June, 05) or equal to 26.5 per cent of total outstanding bank credit.
According to the State Bank, a tight monetary has already been initiated with effect from August, 04.when the rate for export refinance was raised from 2.0 per cent to 2.5 per cent. The essence of the new policy is to increase interest rates at a gradual pace. As a result, the Bank Rate, called Repo, was enhanced from 7.5 to nine per cent on April 11, 05, while the rate for Export Refinance went up from 3.5 to 6.5 per cent,
The banks, in turn, now charge eight per cent from their borrowers for that purpose as against five per cent earlier. The overall weighted average interest rate or rate of return has moved up from 6.49 per cent, as of end-June, 04, to 8.41 per cent on the corresponding date of 05. The rate for deposits also increased but not correspondingly. It rose from 1.21 to 1.85 per cent. The spread between the two rates thus widened from 5.28 percent to 6.56 percent to benefit the banks.
The rate for government securities has also seen increase. The State Bank raised the weighted average yields on three-month and six-month Treasury bills by 2.54 per cent to 7.48 per cent and by 2.44 per cent to 7.94 per cent respectively. The rate for one-year Treasury bills was raised by 2.68 per cent to 8.40 per cent. On September 14, 05, the three rates had reached 8.10, 8.14 and 8.79 per cent respectively.
During the first two months of the current fiscal year, the weighted average of the rate for bank advances has moved up to 9.53 per cent while the rate for deposits has improved to 2.15 per cent.
The weighted average is a handy indicator but does not depict the actual situation, as it is influenced by the extremes. Moreover, there may be a wide dispersion of rates. In that case, one must look at the whole structure of interest rates to pick up the effective rates. Table gives the distribution of bank advances by rates of return on Islamic Modes of financing and reveals an interesting situation..
At the end of December, 04, a huge amount of Rs72.7 billion was advanced to the private sector at zero rate of return, up from Rs31.3 billion in 03, Rs25.8 billion in 02 and Rs11.1 billion in 00 on the corresponding date. This was equal to 5.7 per cent of total financing by banks under Islamic modes of financing. If the figure of Rs32.3 billion for interest-based advances is added, the total works out to Rs105 billion, or 7.6 per cent of total advances under all modes of financing.
This is an intriguing situation. Banks do provide loan facility to some of their employees free of charge but this would be only a fraction of the overall figure. Whatever be the nature of the remaining amount, there can be no denying the hard fact that some other borrowers, in effect, enjoy return-free loans from banks.
The most significant feature of the return structure Islamic modes of financing is that 71 per cent of the advances were made, as of end-December 04, at rates below the inflation rate. In other words, in that case the real rate of return was negative. This provided incentive for hoarding. The most effective rates were four per cent with a share of nine per cent of the total advances, five per cent with 16.7 per cent share, six per cent with 13.3 per cent share, seven per cent with 10 per cent share and eight percent with 9.7 per cent chare. .
Bank credit has two important aspects, namely “cost” of credit and its actual “availability”. Enhancement of interest rates makes borrowing expensive and this has “income” and “substitution” effects. Higher interest payable on borrowed funds, being an expense item, erodes the profit of business and is a burden on the individual borrower.
In this situation, a business concern, if it cannot or does not increase product prices correspondingly, would turn to the alternate sources of financing, like equity. This is substitution effect and is manifested in the relationship between equity and loan financing.
As old calculations are upset by a change in interest cost, this has a bearing on new real investment, discouraging it, if the rate goes up and vice versa. This is the essence of interest rate elasticity of spending for consumption as well as investment. Without going into a detailed analysis of a very complex, rather unique, situation in Pakistan, there is ample evidence of interest rate inelasticity of expenditure.
For one thing, a big influential user of bank credit would give a damn to the rate of interest when he knows that he can default with impunity and can even have the loan written off. The phenomena of huge NPLs and massive write offs are too well known. The interest rate inelasticity is admitted by the State Bank Governor when he says, (Dawn, September 19, 05) “The effort made by the State Bank since early this year to increase yields on T-bills, discount rate and the crawling up of lending rates of the commercial banks have apparently not been able to contain monetary expansion, as evident from the almost Rs400 billion worth of loans provided to the private sector.”
The State Bank Governor is reported (Dawn, Sept.7, 05) to have said, “The monetary policy is being tightened to check inflation which will help in bringing interest rates down.” It is not understood how tight monetary would bring down interest rates, when the opposite is to be expected.
This calls for a word about the market determined interest rate in Pakistan being used as an anchor for monetary policy. It would be a real market determined interest rate, if it is totally worked out by market forces and not in any way influenced by any extraneous factor.
The genuine market forces are the supply of loanable funds derived from public saving and the demands for these funds met from within the market. These basic conditions are not met in Pakistan and in the presence of an important extraneous source of supply of the funds, the existing so-called market determined rate is nothing but just a myth.
The central bank has gone far beyond the limited traditional function of serving as the lender of last resort to become a primary source of capital and injects lots of loanable funds in numerous ways, such as by holding government securities, making investment in and loans to financial institutions, rediscount or purchase of bills, etc. As of end-June 05, the State Bank had injected as much as 16.2 per cent of the total money supply. The ratio was 12.6 per cent a year earlier.
As to the availability of credit, the tightening of monetary policy by way of enhancing some interest rates during FY04-05 had no apparent impact on monetary expansion.
In fact, it is the other way round. In monetary management, increase in Bank Rate and other rates is more of a signal of the central bank view of the situation and a harbinger of restraint on the volume of credit. Thus the essence of tight monetary policy is restraining increase, if not a reduction, in the volume of outstanding credit. While the State Bank increased some interest rates, which were expected to discourage bank borrowing, it has been actively pursuing a policy of stepping up credit expansion and takes great pride. In this way, the State Bank, in fact, has been working at cross-purposes.
It is worth recalling how the present monetary situation has developed. Perhaps the most striking thing is the key role of foreign sector in monetary expansion in recent years. Many thanks to 9\11 which through various, now all too well known, developments brought about a dramatic improvement in the balance of payments. This factor alone was sufficient to create excess liquidity when in most years the growth rate was lacklustre, to say the least.
At the same time, use of bank credit by the private sector was also on the increase. It will be analytically helpful if the period is seen in two phases, namely 01-03 and 03-05. During the first phase, money supply increased by 36.2 per cent as against the real growth rate of 8.4 per cent. Of the increase in money supply, Foreign Assets (net) accounted for 93.2 per cent and Domestic Assets (net) 37.7 per cent-private credit 39.4 per cent. Deficit financing was unusually concretionary by Rs41.7 billion thanks to the IMF programme. The rate of monetary expansion picked up to 18.0 per cent during FY03, even though the growth rate was quite modest at slightly over four per cent.
In the second phase, the rate of monetary expansion rose further to 42.7 per cent. Whereas the expansion due to foreign assets slowed down to account for 10.4 per cent of the total increase, the share of domestic credit shot up to 88.3 per cent-private credit claiming 95.1 per cent.
During FY04-05, the real growth of GDP has been estimated at the historic 8.4 per cent when the rate of monetary expansion was 19.3 per cent. The provisional growth rate is based on incomplete data, and is only a guesstimate. The present ground reality, especially the wheat situation, suggests a lower growth rate.
The extraordinary expansion of Rs528.8 in credit to the private sector during FY05, as compared with Rs325.2 billion is largely explained by consumer loans, which doubled to Rs206 billion. Of the increase in FY05, auto loans accounted for Rs66 billion, having doubled over the year while housing loans shot up from Rs8 billion to Rs27 billion. Personal loans also almost doubled from Rs49 billion to Rs92 billion. Loans obtained through credit cards went up from Rs11 billion to Rs19 billion.
An important development has been the heavy involvement of banks at the stock exchange. Commercial banks have been lending against shares and their own direct investment used to be quite small. In recent years not only their lending has gone up, they have heavy investment in shares on their account.
In 2000, as of end-June, their lending against securities, shares and other financial instruments was Rs30.8 billion and their own investment in others-consisting of shares, debentures, national investment (Trust) units, participation term certificates, Modarbah certificates, mutual funds and others, was Rs55.3 billion. By 04, while the loans rose to Rs83.5 billion, the investment had up to Rs113.5 billion.
The loans against government and trustee securities increased from Rs9.9 billion to Rs17.3 billion while those against shares and debentures rose from Rs1.9 billion to Rs19.9 billion. Banks investment in shares rose from Rs13.4 billion to Rs34.8 billion (book value).
The loans to stock brokers shot up from Rs4.5 billion to Rs21.1 billion. According to the weekly returns, the figure for overall Others had increased from Rs.66 billion in 2000 to Rs141 billion in 04, Rs201.5 billion in 05 and Rs203 billion in August, 05.
Given the time lag between monetary expansion and its ultimate impact on the economy of at least one year, as indicated by the State Bank and mentioned, inflation during FY05, to the extent it could be attributed to monetary factors, reflected the excessive monetary expansion earlier. The impact of record rate of monetary expansion during FY05 is yet to appear.