FALLING oil prices decrease the marginal cost of production for firms. In the ‘general equilibrium’ framework, this encourages firms to increase their output, capital and hire more labour.

While this may have been good news for Pakistan, it is constrained by supply-side bottlenecks to fully benefit from the falling oil prices. In other words, given the energy — electricity and gas — shortfall, firms cannot increase their output following a favourable decrease in their cost of production.

Since the output cannot be increased, the market clears at the point where firms charge prices significantly higher than their marginal costs. I will call this ‘constrained equilibrium’. If the constraint is strictly binding, the economy experiences no change in employment, GDP and prices. But whenever the constraint is removed, firms will increase their output, shifting the economy to higher employment, higher GDP and lower prices.

This has implications for monetary policy. Since monetary policy only affects the demand side of the economy, any change in demand will only affect the price level under the assumption that the energy constraint is strictly binding all across the economy. I will relax this assumption later. Moreover, any fiscal policy not focused on removing the energy constraint will also suffer a similar consequence.

The State Bank of Pakistan (SBP) and Pakistan Bureau of Statistics data confirm the proposition. Immediately after coming to power, the PML-N government cleared the energy sector’s circular debt. This removed the constraint. There was an immediate growth in large scale manufacturing (LSM), and it grew 6.3pc during the first quarter of FY14.

This was achieved despite the increases in domestic oil and electricity prices during the same period. This spurt in growth suggests that the economy was in a ‘constrained equilibrium’.

Given the energy constraints, a purely expansionary monetary policy will only work towards stabilising inflation, while providing limited gains to GDP

However, since the government financed the clearing of the circular debt by borrowing from the SBP, the increase in the money supply triggered an increase in inflation. A 3.3pc month-on-month (MoM) growth in the broad money supply (M2) in June 2013 was followed by 1.5pc MoM non-food non-energy (NFNE) inflation in July 2013. This was much higher than the monthly 0.3pc and 0.4pc NFNE inflation reported for May and June 2013 respectively.

The LSM growth rate declined to only 2pc for the first quarter of FY15. This is not surprising, even though the earlier increase in oil prices during the first half of FY14 had mostly been reversed in the fourth quarter of that fiscal. There is little evidence to suggest any adverse change in demand which might have slowed the LSM growth.

The primary cause for this slowdown is the circular debt, which was reported to have risen to around Rs400bn by the first quarter of FY15 — only a little less than the Rs480bn that was cleared a year before.

The economy will grow faster in response to falling oil prices since the energy constraint is not strictly binding all across the economy. The agriculture and services sectors are not as dependent on energy (electricity and gas) as the manufacturing sector. Declining oil prices will, therefore, work towards increasing GDP by raising production in sectors of the economy that are less dependent on electricity and gas.

However, there is little reason to believe that the government will be able to meet its GDP growth target of 5.1pc for FY15 while the energy constraint persists. The World Bank, IMF and ADB have all projected the GDP growth rate to remain below 4.5pc. With returns and growth of the production sector constrained, it is no wonder that banks find it preferable to invest in government securities rather than in high-risk private investments.

But it’s not all doom and gloom. The SBP is on its way to adopting an expansionary monetary policy following downward inflation trends. Monthly NFNE inflation declined to 0pc and 0.1pc in February and March respectively.

However, given the energy constraints, a purely expansionary monetary policy will only work towards stabilising inflation, while providing limited gains to GDP. There is little hope that the private sector alone will be willing to fill in the investment vacuum in the energy sector, given the deep-rooted governance, transparency and capacity issues.

Nonetheless, we are presented with a window of opportunity where the SBP can direct funds towards government investment for solving supply-side bottlenecks — transmission lines, distribution networks etc — without fearing inflationary consequences.

The writer is a PhD student in macroeconomics at the University of Bristol, UK. He has earlier worked at the Planning Commission of Pakistan and Cambridge Econometrics, UK.

ajpirzada@hotmail.com

Published in Dawn, Economic & Business, April 27th, 2015

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