Monetary policy: some observations

The State Bank has imposed a crippling high-interest rate regime on Pakistan over the past several years due to its conclusions that prices were rising at an unacceptable rate because of:

a. Excessive demand, mostly for goods and possibly also for services, characteristic of an ‘overheated’ economy.

b. Excessive growth in monetary aggregates, which in monetarist theory results in higher prices as more money chases goods (and services) which do not rise as much if production lags.

It follows that the central bank feared that unless rates were maintained at high and ‘attractive’ levels the consequences would be highly damaging to the economy:

a. Inflation would accelerate, even run out of control with the specter of hyperinflation

b. The Rupee would fall at an undesirable accelerated pace, leading to higher prices for imports which would feed into inflation

c. If real rates were to be perceived as ‘negative’, ie the return to investors was less that the rate of inflation, then savings would evaporate and the public would rather spend than save and watch the purchasing power of their savings diminish.

d. The IMF and other international agencies would consider lower rates as financially irresponsible, thus reducing our eligibility for further borrowing.

The central bank possibly leaned on the monetarist experience of the US Federal Reserve, notably the controversial policy of Paul Volker who drove rates briefly to near 20% in 1980-81 with inflation collapsing shortly thereafter but creating an extraordinary painful recession and high unemployment.

With the above rationale, the policy of high interest rates presumably was supposed to yield the following results:

a. Depress demand in the economy by making borrowing more expensive which would result in inflation falling to at least single digits in fairly short order

b. The Rupee would not depreciate at an undesirable rate, not exceeding the weighted inflation differential with our trading partners

c. After a period of administering the medicine, inflation would be under control, employment and the economy would recover and the country would embark on rapid economic growth.

I would expect that the inflationary growth in monetary aggregates resulting from remittances from abroad were addressed with the appropriate sterilisation measures by the central bank.

The above conclusions have been reached in the absence of any detailed explanations by the policy makers in their published reports elaborating on the theoretical and empirical foundations of their conclusions, and given that no hearings on monetary policy were held by parliamentary committees, no doubt due to lack of technical support and experience.

As an observer of the macroeconomic scene in Pakistan over the past few years, I have noticed the following alarming developments with dismay:

a. Business, industry and employment have suffered grievously for reasons both financial and otherwise, such as energy and law and order. Unemployment is widespread in the absence of job-creation by the private sector and the public sector already saturated.

b. Non-performing loans shot up at banks as borrowers have either refused to pay enormous debt service amounts or have been unable to generate sufficiently high rates of profits to generate the capacity for debt service at 15 – 20% as there are no businesses that can yield such returns after expenses! Banks have also had to write-off loans in huge amounts.

c. Banks became reluctant to lend to commercial borrowers, choosing instead to place funds with the government, resulting in another depressant to economic activity.

d. Interest rates were maintained at prohibitive levels for a very prolonged period allowing the market to adjust to them to some extent, reducing the efficacy of prolonged high rates.

e. Savers, both individual and corporate, placed their funds in passive high-yield deposits rather than deploying them in business and entrepreneurial activity with highly damaging distortions in the patterns of investment, depressing enterprise and business activity.

f. Inflation also resulted from higher imported oil prices, appreciation of the yen (until recently), and by the administered wheat purchase price which exceeded even international levels! The explosive borrowing by the government injected money into the economy with little resultant productivity adding thereby to inflation. The tight monetary policy was useless against exogenous factors and was counterproductive by increasing interest expense on the public debt.

g. Debt service on the national debt became shockingly huge as the biggest charge on public revenues, reducing fiscal space for national development to woefully inadequate amounts.

h. The rupee fell in any case from about 62 to 100.

Pakistan’s economy became moribund with a rate of growth not even matching the population growth and with a substantial increase in the percentage of the population sinking into poverty and there was no evidence of a healthily growing economy let alone an ‘over-heated’ economy.

It is instructive that virtual-zero interest rates in the US, Japan and other countries over the past several years have failed to result in any inflation and the US Federal Reserve has indicated that unless unemployment falls below 6.5% the rates will remain between 0 and 0.25% p.a.

In Japan, the new government has embarked on a dramatic stimulus plan that raised the acceptable inflation target, injected huge money supply into the system and engineered a massive devaluation of the yen. It has been devalued from 79 in October 2012 to 100 to the dollar currently, ie about 27%! This sparked a 50% rally in the stock market as the export competitiveness of Japan improved. The contrast with our own policies is extraordinary.

Conclusion: In view of the preceding observations, I would suggest that the past approach has been inappropriate and urge the incoming government to introduce a major change in Pakistan’s monetary policy with an immediate decisive cut in the discount rate. This would take advantage of the window before IMF is approached for a foreign currency bail-out which may be necessary if other measures being considered are not successful or timely. Such a step would address the elements of the alarming situation described above and become the first component of the critically-needed economic recovery plan for Pakistan.