Why the dis­count rate hike?

The Pak Banker - - 4editorial - Dr Ash­faque H Khan

The State Bank of Pak­istan (SBP) has in­creased the dis­count rate by 50 ba­sis points (0.5 per cent) to 14 per cent with ef­fect from Nov 30. Was this in­crease jus­ti­fied? While an­nounc­ing its mon­e­tary pol­icy, the SBP jus­ti­fied it as a move coun­ter­bal­anc­ing "the rapid ex­pan­sion in re­serve money and ar­rest the ris­ing in­fla­tion ex­pec­ta­tions." The per­sis­tent in­crease in in­fla­tion can be at­trib­uted to re­lent­less govern­ment bor­row­ing from the SBP to fi­nance fis­cal deficit, says the Bank.

Mon­e­tary pol­icy is an im­por­tant in­stru­ment of sta­bil­i­sa­tion pol­icy. It has been found to be an ef­fec­tive in­stru­ment in con­trol­ling ag­gre­gate de­mand, and there­fore in­fla­tion. There are at least three rea­sons for tight­en­ing of mon­e­tary pol­icy. First, it helps to con­trol the per­sis­tent rise in price level. Sec­ond, it cur­tails ag­gre­gate de­mand with a view to im­prov­ing ex­ter­nal bal­ance of pay­ments and re­duc­ing in­fla­tion. Third, it dis­cour­ages the govern­ment from bor­row­ing from the SBP to fi­nance fis­cal deficit.

Let me deal with the first is­sue first. In­fla­tion av­er­aged 14.2 per cent in the first four months of the cur­rent fis­cal year (July-Oc­to­ber), com­pared to the same pe­riod last year. In­fla­tion in Oc­to­ber stood at 15.3 per cent. The prin­ci­pal con­trib­u­tor to the re­cent surge in in­fla­tion has been the sharp in­crease in food in­fla­tion. Food in­fla­tion av­er­aged 13.7 per cent from Novem­ber 2009 to July 10, but rose sharply to an av­er­age of 19 per cent dur­ing Au­gust-Oc­to­ber 2010.

Food in­fla­tion was up 20.1 per cent in Oc­to­ber. Fuel and light­ing and trans­port and com­mu­ni­ca­tion also re­mained el­e­vated at 21.2 per cent and 18.5 per cent, re­spec­tively. A cur­sory look at the in­fla­tion fig­ures would show that food in­fla­tion alone con­trib­uted 55 per cent in the rise of over­all in­fla­tion. Fuel and light­ing and trans­port and com­mu­ni­ca­tion con­trib­uted 11.3 per cent and 9.1 per cent, re­spec­tively.

Crop dam­ages and sup­ply dis­rup­tion as a re­sult of the un­prece­dented floods played im­por­tant roles in the surge of food prices. Govern­ment-ad­min­is­tered in­creases in fuel prices and power tar­iff also con­trib­uted to the in­crease in the gen­eral price level. Thus, food, fuel and trans­port and com­mu­ni­ca­tion to­gether con­trib­uted 75 per cent to the re­cent surge in gen­eral prices. Should we be­lieve that the rise in the dis­count rate the prices of food items will come down and the govern­ment will stop in­creas­ing fuel prices and power tar­iff? Per­haps the gover­nor of the SBP thinks so.

Cen­tral banks around the world tar­get core in­fla­tion in the con­duct of mon­e­tary pol­icy, not head­line in­fla­tion. Non­food, non-en­ergy in­fla­tion (core in­fla­tion) is on the de­cline since June and was 9.3 per cent in Oc­to­ber, as op­posed to the head­line in­fla­tion of 15.3 per­cent. This clearly sug­gests that the cur­rent in­crease in in­fla­tion is due to the rise in food and fuel prices and trans­port charges, for which the mon­e­tary pol­icy is not an ef­fec­tive in­stru­ment to con­trol the sit­u­a­tion. Sec­ond, one of the ob­jec­tives of tight­en­ing mon­e­tary pol­icy is cur­tail­ment of ag­gre­gate de­mand and restora­tion of bal­ance in the econ­omy. Ex­ces­sive ag­gre­gate de­mand will be re­flected through the widen­ing of cur­rent-ac­count deficit. Cur­rent-ac­count deficit was down by 55 per cent in the first four months of the cur­rent fis­cal year. In fact, cur­rent ac­count re­mained in sur­plus dur­ing the months of Septem­ber and Oc­to­ber. A sharp re­duc­tion in cur­rentac­count deficit sug­gests sig­nif­i­cant re­duc­tion in im­bal­ances and ab­sence of ex­ces­sive de­mand. This can also be cor­rob­o­rated by sales-tax col­lec­tion from do­mes­tic eco­nomic ac­tiv­ity which was up 8.0 per cent dur­ing the first four months of the cur­rent fis­cal year de­spite a 1.0-per­cent­age-point in­crease in the sales tax rate and 15 per cent in­fla­tion. Was a fur­ther hike in the dis­count rate jus­ti­fied in the wake of the col­lapse in ag­gre­gate de­mand? Per­haps the gover­nor of the SBP thinks so.

Third, yet an­other ob­jec­tive of tight­en­ing mon­e­tary pol­icy is to dis­cour­age the govern­ment from bor­row­ing heav­ily from the SBP to fi­nance fis­cal deficit. Govern­ment bor­row­ing from the SBP is the main source of the surge in re­serve money growth. Dur­ing the last four-and-a-half-months, the govern­ment has bor­rowed Rs265 bil­lion, against Rs16 bil­lion in the cor­re­spond­ing pe­riod last year. As a re­sult, re­serve money has grown by 18.4 per cent, against 9.7 per­cent last year. Per­haps the SBP be­lieves that a rise in dis­count rate will dis­cour­age the govern­ment from bor­row­ing from the cen­tral bank. The SBP has for­got­ten that by rais­ing the dis­count rate by 100 ba­sis points in the cur­rent fis­cal year, it has in­creased the in­ter­est pay­ment of the govern­ment by al­most Rs50 bil­lion. Thus, ev­ery­thing be­ing held con­stant, the bud­get deficit will in­crease by Rs50 bil­lion. Hence, more deficit, more bor­row­ing, a fur­ther hike in the dis­count rate, fur­ther in­crease in in­ter­est pay­ment, and fur­ther in­crease in bud­get deficit. Do we want to cre­ate a vi­cious cir­cle?

Per­haps the SBP be­lieves that by in­creas­ing the dis­count rate it will en­cour­age com­mer­cial banks to par­tic­i­pate ac­tively in auc­tion of govern­ment debt. In other words, it will shift govern­ment bor­row­ings from the SBP to sched­uled banks. Govern­ment bor­row­ings from the sched­uled banks stood at Rs76 bil­lion, against Rs164 bil­lion in the same pe­riod last year. Per­haps the sched­uled banks are de­lib­er­ately avoid­ing par­tic­i­pa­tion in the auc­tion to the ex­tent they should have been.

Newspapers in English

Newspapers from Pakistan

© PressReader. All rights reserved.