In the previous article published in EBR dated 7-13 April, 03, it was shown that the management of the State Bank of Pakistan (SBP) did not present a clear perception of (i) determinants of monetary assets and their two components viz. monetary liabilities of the SBP and monetary liabilities of scheduled banks; (ii) the process of credit creation; and (iii) the building up of credit pyramid on reserve money.
The object of this article is to show as a next step that the SBP is also not clear about the true nature of the relationship between the banking system, comprising the SBP and the scheduled banks, and the non-bank financial institutions, especially the Central Directorate of National Savings. That is why the bank has come up with the following implausible suggestions:
1) “The linkage of profit rates on the NSS and the PIB should be strengthened. It is suggested that the government could maintain a fixed differential between the NSS and the PIB rates. When this differential crosses the set limits, the rates should be adjusted. And the pre-announced schedule of rate adjustment be abandoned.”
2) “A more viable alternative, however, is to cap borrowing from the NSS to the budgeted level. This would (a) cap the government’s losses due to the interest rate differentials, and (b) limit the disruptive impact on the conduct of monetary policy, by ensuring more deterministic flows. At the same time, pensioners and widows etc. could retain access to the recently announced Pensioners’ Benefit Account Scheme offer(ed at) slightly higher return.”
As an illustration of the SBP views on the NSS, quotations from its publication are set out in section I. The appraisal of the SBP views is given in Section II.
(i) Financial Sector Assessment/90-2000: “The higher profit rates on the NSS investment, along with lower deposit rates in banking sector played a crucial role in diverting funds to the NSS, which is known as the process of disintermediation.” (p.76)
“The higher profit rates on the NSS have diverted deposits from banking sector to these lucrative instruments, and resulted in lower deposit base of banks, particularly in late 1990s. This was, in fact, a reinvigoration of financial repression and went against the basic objective of financial reforms.” (p.77)
(ii) The State of Pakistan Economy (October-December/2002: “While the fiscal performance and the availability of relatively cheap external financing are positive, the greater dependence on non-bank borrowings is trembling.” (p.42)
“Since the NSS instruments are sold “on tap” the financing sought by the government from the market is a residual net of the NSS flows. In other words, the government must, perforce, accept expensive debt in place of cheaper debt, severely constraining its ability to lower its debt servicing costs... In fact, the government was borrowing funds from banks at 4 per cent or less, while simultaneously offering individual investors a return of 10-12 per cent through the NSS instruments.” (p.43)
“Specifically, the financial industry sought the elimination of NSS schemes.... However, the government preferred to simply lower the interest rate differentials. “(p.98)
SBP views: Let us examine the SBP’s views regarding the implications of savings mobilized by the Central Directorate of National Savings (CDNS) under the NSS for different sectors of the economy.
(1) We begin with the critical analysis of the SBP’s assertion that the larger mobilization of resources by the CDNS was attributable to diversion of funds from bank deposits to instruments issued under NSS since these were more lucrative than bank deposits. This is not a correct interpretation of facts on the ground.
The purchase of financial instruments of savings issued by the CDNS under the NSS, such as the DSCs, the SSCs, etc. has no effect whatsoever on the level of bank deposits. The SBP analysts seem to have fallen into the fallacy of composition. They consider term deposits with banks and financial instruments of savings issued by the CDNS as two competing outlets available to the public for the placement of their savings.
This may be true at individual level as he has the option to place his savings either with a bank in the form of term deposits or purchase the DSCs/SSCs. In each case, however, the impact on the economy would be quite different. If the individuals decide to place their savings in term deposits with banks, there would be increase in bank deposits held by the public but that would be counterbalanced with an equivalent decline in currency in circulation held by the public, so that total monetary assets in the economy would remain unchanged. Hence in this case there would be no increase in financial savings in the economy. On the other hand, if they decide to purchase the DSCs/SSCs, there would be an equivalent increase in overall financial savings in the economy.
Secondly, this view of the Bank shows that they lack understanding of determinants of level and changes in monetary assets. As is well known, monetary assets have two components:
(i) currency in circulation and “other deposits”, which are liabilities of the SBP; and (ii) bank deposits which are liabilities of the scheduled banks. Monetary survey issued by the SBP lumps determinants of level of monetary assets (stocks) and changes in monetary assets (flows) under two broad heads: net domestic assets (NDA) and net foreign assets (NFA). It contains further information about broad categories of NDA. It is pertinent to remember that it is always the assets side of the balance sheet that determines the liabilities side of the balance sheet, and never the other way round.
Let us take another example to examine the impact of purchase of the NSS instruments on the banking system. Suppose some depositors decide to withdraw their low yield term deposits from banks and place them in high yielding financial instruments issued by CDNS. Bank deposits do decline when depositors draw cash from the banks, but decline in bank deposits is counterbalanced by an equivalent increase in currency in circulation.
The holders of monetary assets then shift from deposits to currency, and vice versa, but they cannot change their outstanding level. Monetary assets decline only if borrowers from banks were to reduce their debt to the banking system, i.e. there was decline in the NDA and/or the NFA. So, whenever people place their funds in non-monetary financial assets like the DSCs, etc, that invariably represents an addition to financial savings, monetary and non-monetary, in the economy and not a shift from monetary assets, or from any of its components, to non-monetary financial assets.
(2) In the interest of efficient monetary policy, interest rates on the NSS instruments were reduced drastically; institutional investors were banned to purchase these instruments in March, 2000; while 10 per cent withholding tax was imposed in FY 02. Since yield on marketable government paper, i.e. PIBs and TBs also fell sharply during this period, the difference between yields on marketable and non-marketable government debt remained high, which was claimed to be detrimental to efficient monetary policy.
To deal with these thorny problems of mobilization of large amounts of resources under the NSS, so disruptive to the conduct of monetary policy and causing losses to the government, the bank has suggested “to cap borrowings from the NSS to the budgeted level” though the proper course would have been to do away with NSS altogether.
In our view, larger mobilization of resources under the NSS should have positive impact on monetary policy. The government’s need to borrow from the banking system to meet budgetary deficit would be reduced to that extent. Thus the banking system would be able to extend larger amount of credit to the private sector within the given safe level of domestic credit expansion (DCE).
The growth of economy and the level of employment depend on the rate of capital formation which, in turn, is determined by the level of savings in the economy. The level of national savings is extremely low compared to that in India, Malaysia, Korea, China, etc. The bulk of national savings originates in the household sector and popularity of financial assets offered under the NSS for placement of household savings is second only to the monetary assets offered by the banking system.
Monetary assets being means of payment, there is a limit up to which the banking system can mobilize resources without generating inflationary pressures. There is no such limitation on the mobilization of household savings under the NSS. Thus, if the advice of blinkered policy makers were implemented, it would have serious implications for the economy. Already, the mobilization of resources under NSS, after rising from Rs114 billion in FY-98 to Rs142 billion in FY-99, declined to Rs95 billion in FY-00 and further to Rs51 billion in FY-01, though it improved to Rs91 billion in FY-02 owing to sharp rise in inflow of home remittances.
The SBP’S preference that the government should borrow cheap from abroad to meet its fiscal deficit over mobilization of domestic savings at a relatively higher cost to meet this deficit is shortsighted and harmful for the economy in the long run.