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Failings of the State Bank

All over the world, central banks perform three main functions. First, they formulate and conduct monetary policy with the objective of keeping monetary expansion and inflation under control, and channelling bank credit to productive activities so as to facilitate economic growth. Second, in most cases they are responsible for sanctioning, regulating and, if necessary, winding down of the commercial banks. Third, central banks are supposed to manage the exchange rate so as to ensure relative stability in the external value of the national currency.

Prior to 1993, the State Bank of Pakistan (SBP) did not have legal authority to perform any of the three functions without the approval of the government, which made it de jure subordinate to the Ministry of Finance. It also led to the submergence of the monetary policy under the fiscal policy, which encouraged budgetary and monetary indiscipline and led to a banking crisis by the early 1990s.To rectify the situation, during 1993-97 the SBP focused on changing the legislation so as to enable it to function as a truly autonomous and effective central bank.

Never before, or after, have so many legislative reforms been introduced in the banking sector as was done during 1993 97. The SBP Act was changed twice to make the board of directors and the governor legally immune from political interference and equip them with legal powers to formulate and implement an independent monetary policy. New provisions were added in the SBP Act to enable it to have control on sources of creation of high-powered money, including government borrowing from the SBP.

For this purpose, and in case the government failed to reach an understanding with the SBP through a legally constituted process of consultation, the SBP was empowered to deny credit to the government beyond a prudent limit. The SBP governor was guaranteed protection of tenure and, once appointed, he/she could not be removed by the government due to policy differences. To facilitate the process of monetary policy formulation, an analytical framework was also put in place at the SBP.

Equipped with professional expertise, security of tenure and the authority to ‘determine and enforce’ government borrowing from the banking system in addition to regulation of bank credit to the private sector, the SBP governor was supposed to participate in macroeconomic management of the country as equal partner with the Ministry of Finance. In particular, the governor was required to regulate the growth of money consistent with the genuine requirements of the economy. In summary, the wherewithal was put in place to enable the SBP to pursue an independent monetary policy on a professional basis.

Legislative reforms were also introduced to strengthen the regulatory authority of the SBP. The Banking Companies Ordinance was amended to give the SBP all the powers for the regulation and control of the banking system without the involvement of the government. In fact, the government was explicitly prohibited by the legislature through section 46(b) of the SBP Act from directly or indirectly, verbally or in writing, issuing any directives to the banking system without the consent of the SBP.

The Banks Nationalization Act was amended to abolish the Pakistan Banking Council to make the SBP the sole regulatory authority and to improve the governance structure of the public sector banks prior to their privatisation.

Simultaneously, the banking supervision apparatus and its technical capacity were strengthened to increase the effectiveness of SBP surveillance over commercial bank. In the matter of the exchange rate, legislation was passed to make it market based with the SBP playing a central role in its proper management. The entire purpose of these legislative and institutional reforms was to create a solid legal foundation for the SBP to discharge its duties professionally without undue political interference.

It was expected that the SBP would follow the new legal framework in the conduct of its business and establish itself as a truly autonomous central bank. But laws cannot enforce themselves; they require commitment to translate them into effective operational instruments. A review of the recent performance of the SBP shows that it has failed to effectively perform most of the vital functions assigned to it through the above legislative reforms.

In the monetary policy area, the SBP’s board of directors has failed to discharge its statutory responsibility of containing monetary expansion within safe limits that keep inflation under control. Not only that, the board has gone a step further to assert in its Third Quarterly Report for FY13 that the use of the SBP legal power in the matter of monetary management will “seize up the money and foreign exchange markets” and “trigger a full blown banking crisis”.

This is, to say the least, an absurd observation coming from the central bank of the country. The fact is that it is the SBP’s failure to undertake its statutory functions that has driven the economy and the banking system towards a crisis.

Moreover, the SBP prematurely lowered the policy rate in several steps in the last year under instructions from the finance ministry. It will now reverse the same under pressure from the IMF. It is clear that the SBP is doing the bidding of the government or the IMF, rather than acting as an independent and professionally competent central bank in monetary management. In the process, its national and international stature as a central bank stands eroded.

The second main task of the SBP to effectively regulate the banking system of the country professionally without the involvement of the government has also not been done properly. The Ministry of Finance has been allowed to openly and blatantly interfere in the affairs of banks. No attempt has been made to improve the governance structure of banks by creating a firewall through prudential regulations between the ownership, board of directors and professional staff of banks.

Banking operations continue to be manipulated by large shareholders to reap unreasonable profits. Banks are allowed to maintain a high spread between the average lending rate and the average deposit rate to the detriment of the interests of both depositors and borrowers. The quality of the assets of banks has been compromised due to a predominant share of government securities in their asset portfolios. The interests of the depositors have not been protected by ensuring a positive real rate of return on their savings.

In the matter of the exchange rate, the SBP has been reacting to the developments in the market rather than controlling them. There has been no attempt to integrate the exchange rate policy with the fiscal and monetary policies. Without recognising that there is a trade-off between the nominal exchange rate and fiscal and monetary policies, the SBP has been engaged in a futile exercise of keeping the nominal exchange rate stable while inflating the economy by excessive money creation. This has led to a rapid depletion of the foreign exchange reserves creating a balance of payments crisis.

The SBP needs to move back on the path that was legally created to make it an effective and autonomous central bank playing a key role in the macroeconomic management of the country, ensuring control on money supply and inflation, developing the banking system on sound footing by improving their governance and imparting stability to the nominal exchange rate by following a prudent demand management policy rather than through loss of reserves or use of administrative instructions.

The writer is a former governor of the State Bank of Pakistan.

Dr. Muhammad Yaqub, "Failings of the State Bank," The News. 2013-08-17.
Keywords: Economics , Economic issues , Economy-Pakistan , Monetary policy , Economic growth , Government-Pakistan , Economic policy , State Bank-Pakistan , Economic inflation , Foreign exchange , Budget deficit , Foreign debts , Exchange rate , Fiscal policy , Macroeconomics , Pakistan , SBP , IMF