The recent monetary policy announcement by the new State Bank governor sends a clear message: that there is little in terms of improvement in the state of the economy to warrant the much demanded monetary loosening.

Based on traditional logic, the stance is correct; while fiscal, trade and current account deficits are already high there may be further slippages. First, with Federal Board of Revenue (FBR) collecting only Rs544 billion in first half of FY09, the full-year Rs1.36 trillion tax revenue target may not be met. Impliedly, public borrowing could stay high squeesing credit to the private sector, which won’t help contain the economic downswing.

Second, anticipated decline in trade deficit (courtesy falling imports) may be less than expected since: (i) export growth may decelerate due to global recession and infrastructure bottlenecks causing intermittent power and gas supply shortages; (ii) anticipated decline in oil import bill may turn out to be less than its projection.

Besides, deceleration in Consumer Price Index since September 2008 was moderate relative to Sensitive and Wholesale Price Indices, while Core Inflation Index (the peg for interest rates) remains what the governor called “stubborn”. According to him, “this signifies that demand pressures have not completely dissipated despite a slow down in economic activity.”

For once, SBP explicitly accepted that accumulation of excess demand since 2004 prepared the slope for inflation to slip uncontrollably, and in 2008 it caused multiple deficits, raised production costs all round, and blunted growth. To limit its fallout, SBP considered it expedient to continue its tight policy stance and to keep its discount rate unchanged at 15 per cent.

The policy highlighted the vulnerabilities (principally high imports) nourished by a stable rupee, that eventually caused sudden widening of the current account deficit after global financial turmoil and Pakistan’s political turbulence triggered a fall in reserves, quick depreciation of rupee, and rapid rise in inflation because exchange rate adjustments weren’t based on inflation differentials and trade deficit.

Beginning 2004, demand for goods steadily overshot supply due to excessive private sector borrowing fuelled by low interest rates. In 2007, government borrowing rose rapidly owing to delayed pass through of fuel subsidies amounting to Rs395 billion out of the fiscal deficit of Rs777 billion, which was sheer bad fiscal management.

Excess credit expansion was reflected in banks’ high loan-deposit ratios; later it led to an unprecedented market ill-liquidity; between July 1 and January 10, deposits shrank by Rs128 billion (3.4 per cent), while bank credit soared by Rs 500 billion (11 per cent) placing a combined strain of Rs628 billion on the system and shrinking its liquidity by 14 per cent, forcing SBP to continue its tight monetary stance.

Denying a relationship between discount rate and lending rates, SBP views the liquidity gap as the counterpart of the Current Account deficit, and believes that such a large drop in liquidity would have raised interest rates regardless of the SBP discount rate level. Indeed, 6-month Kibor eased by 55 bps to 15.21 per cent from 15.76 per cent in November 2008, and 3-month Kibor by 98 basis points.

This is where truth begins to surface i.e. over-simplification of the logic about interest rate rise since SBP also regrets the dismal performance of the large scale manufacturing sector that, for the first time since 2004, fell by 5.6 per cent, as well as falling private sector credit, all during the first five months of current fiscal year that together portray definite weakening of the economy.

Drop in private sector credit doesn’t reflect industry’s reduced funding needs but the fact that interest rates are too high to make an economic activity viable while domestic and foreign markets reflect falling demand as disposable incomes slide. SBP admits these realities as well as the impact of “power cuts and long interruptions” but not that of high interest rates in slowing the economy.

The fallout from economic slow down will be accentuated by relying on macroeconomic indicators with a history of (often wilful) miscalculation. Yet, SBP didn’t realise that while the industry confronts cost escalation due to a host of factors (none resolvable quickly) lower borrowing cost could be the immediate relief; without it more businesses could close and worsen banks’ perception of lending risk.

SBP notes banks’ overzealous participation in T-Bill auctions as well as the fact that banks’ T-Bill stocks “over and above the SLR indicate their [banks’] reluctance to extend credit to the private sector”, as also the fact that it is “an indication of growing risk aversion”. It also overlooks the fact that Kibor is falling not because banks are lending cheap; they prefer low-yield zero-risk business i.e. investing in T-Bills

According to SBP bulk of the surplus liquidity (that rose from Rs79 billion in end-September 2008 to its current level of Rs325 billion) has gone into T-Bills and “has not only pulled down the Kibor rates (i.e. Karachi Inter-bank Offer Rates) but has also reduced the inter-bank spreads between the repo and the call rates”. The term to note here is ‘inter-bank’.

Will the shifting of bulk of the national savings from the private sector to the exchequer yield the desired results in economic growth? A yes to this question implies overconfidence in the bureaucracy’s ability to generate optimum value from wealth placed at its disposal – a phenomenon not witnessed since the late 1960s; it is even less likely now.

SBP offer to provide another Rs25 billion for concessional export re-finance is generous but SBP again failed to note that Part-II (pre-shipment finance) of this scheme is often misused. An imaginative step would have been to offer this amount only for Part-I (post-shipment finance) that rewards real exporters not those investing the pre-shipment finance in speculative ventures.

Finally, the policy seems geared to facilitate government borrowing. While initially SBP announced that it will continue to manage the operational aspect of the auctions without any change in the process as far as the market was concerned, it was subsequently announced that, henceforth, the government will decide the rates of return to be offered on T-Bills and PIBs.

This again reposes excessive confidence in bureaucrats’ ability to respond correctly to the scenario characterised by the inter-relationships between existing stock, demand, and supply of money, and private sector credit needs. What is positive (though more of a hope) is the plan for “segregation of debt and monetary management” and “introducing limits on direct government borrowings from the SBP”.

But the promises about prior announcement of the auction calendar for T-bills and PIBs, a volume-based approach to determining the auction result, and quarterly (instead of half-yearly) policy statements, may yield the desired results.