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Review of monetary policy and need for a new budget

The SBP Monetary Policy Committee (MPC) in its meeting held on 14th July has announced the monetary policy for the next two months. The review presented to the MPC was grim: reserves were depleting fast, as current account deficit kept widening and country’s oil bill would be rising as prices continue to rise. It acknowledged that the aggregate demand was too high and unsustainable. It therefore decided to give the strongest signal yet in three years of the need to decelerate the demand. The policy rate was increased by 100 bps to 7.5% – highest in nearly three years. Other significant developments noted by MPC included the exceptionally high lending by commercial banks to the private sector. The inflation has seen a sustained increase both in CPI (5.2%) and core inflation (7.1%) and the Bank has revised its forecast for next year inflation to 6-7% as opposed to less than 4% during the last year. In view of these adverse developments, the growth forecast has been revised to 5.8% from 6.2%.

The monetary policy action was in the right direction although it has been delayed for a long time. In these pages, for nearly a year, we have been impressing that the aggregate demand was too high and fueled primarily by a combination of excessive fiscal deficit and an accommodative monetary policy, and that the country would soon run out of external resources to finance the external account. When things have reached a point of impossibility, the standard medicine is no longer effective.

We saw it the other day, as within hours of opening of markets on Monday, the worst day in exchange rate market was in witness. The rupee lost a massive Rs 7 against the dollar in a single day or 6% of its value. Continuing on this path would carry the risk of further destabilizing movements in the market and as such the Government and SBP have to think of other ways to deal with this draining state. If we continue on this path the process of attrition would only accelerate: losing the value of the currency and chasing something (stability) that would remain elusive. In the process we are dropping our hand when we would finally sit across with the IMF for a bail-out program once a new Government is in place. The measures adopted would have earned us some points to deal with the conditions for a new program.

Given the fact that until a new Government is in place, no meaningful correction job would be taken in hand, it is high time that the Caretakers, with the assistance from SBP, launch a rearguard action to slow down the aggregate demand. The Government should stop all spending on account of development budget as well as from all special allocations on the current side until the new Government takes charge. A variety of discretionary expenditures within the current budget such as cars, ACs, office furnishing and travel should be banned across the board. A stronger measure would be to stop all payments except pay and allowances.

The SBP would do well to check the demand for foreign exchange by adopting some extra-ordinary measures – even going beyond those announced today – such as a very high margin requirement on all LCs and further lengthening of the notice period for LC opening which was recently announced. In fact, given the severity of the crisis, SBP may remove the petroleum import financing from the inter-bank market and take this responsibility. A great deal of room for SBP purchases would be created once this single largest item of inter-bank demand is off the table.

What we have suggested is undoubtedly retrogressive steps. Their justification is based on only two accounts. First, we are facing an emergency situation, and second, these are temporary measures to be removed as soon as the country is in a position to conduct its economic affairs in an orderly fashion. These measures would act to cool-off an extremely overheated economy. These would be withdrawn as part of the stabilization program.

The new Government has to abandon any thought of celebrating its electoral victory and enjoying a honeymoon period. There is no time available to waste. Most importantly, it would be a folly to depend or even experiment with novel ideas at this point in the poor state of the economy. A plain vanilla recipe of agreeing to a Fund program is the only viable option. This would mean that there would be a period of austerity which the nation must be prepared for.

The new Government would have to give its budget to the nation and repair the damage caused by the outgoing Government. The year has shown an exceptionally poor tax performance, with the base at Rs 3751 billion, showing a less than 10% growth during the year. This was Rs 214 billion less than the revised target of Rs 3,965 billion and Rs 262 billion less than Rs 4015 originally targeted in the budget. With such poor record, the next year’s growth in tax revenues was budgeted at 13%. This growth would now be 20% with the reduction in the base. Where would this massive growth in taxes come from when the full effects of inappropriate and undue concessions doled out by the Government would be borne during this year? The massive reduction in individual tax rate from 35% to 15% would be anywhere from Rs 100-150 billion. That reduces the potential tax collection further.

This means that the required tax effort would be very high to achieve a modicum of stability. But equally importantly the deficit that was projected to be 5.5% at the time the new budget was presented in April, is closing at a minimum of 7.1%. This was not due the effects of one-off items but the structural imbalances afflicting country’s finances. The new Government would be confronted to explain where would it make up for the excess expenditures and low revenues to balance the budget at 4.9% bequeathed to them by the outgoing government.

The bottom line is that the new Government would have to present a new budget which would be radically different than the one the last Government made and got it approved from the Assembly, knowing fully well that it was not its business and didn’t concern them. That revised budget would very likely carry a fiscal deficit target of 5% during the year and spell out the measures to cut the deficit by 2.1% expended by the last Government. It would comprise both new tax measures (including the roll-back of concessions mentioned above) as well as expenditure reductions. This is a tall order and would only be possible when a Government has the peoples’ mandate to take difficult measures, asking for sacrifices, but unequivocally establishing its own credentials to offer sacrifices more than being asked from the people.

Waqar Masood Khan, "Review of monetary policy and need for a new budget," Business Recorder. 2018-07-18.
Keywords: Monetary Policy Committee , Commercial banks , Standard medicine , Overheated economy , Tax performance , Electoral victory , IMF , MPC , SBP , CPI