Last Thursday, the State Bank appeared to have woken up to the fact that the country was facing high inflation and increased the benchmark rate by a record 150 basis points. This followed the earlier four hikes of 50 basis points each in April 2005, July 2006, July 2007, and January 2008. These abrupt and harsh measures could undermine the credibility of the bank.

The State Bank Governor’s statement contained many contradictions that need careful examination but the knee-jerk nature of the measures point to a major shortcoming: the bank failed to anticipate the rapid deterioration in inflation, growth and other key macro indicators. For example, its January 2007 monetary policy statement had noted, “while inflation is likely to ease-off further it may remain above the target 6.5 per cent target for unless come additional administrative measures are taken to reduce food inflation.”

A core function of a central bank is to anticipate inflation and growth trends and conduct its monetary policy accordingly because it can take around 18 months or so before the impact of its tightening or otherwise is felt on inflation. This requires analysis of historical information as well as judgements about the future trends especially in a developing country like Pakistan where the data is not always up-to-date and reliable.

The bank had maintained in its July 2007 monetary policy statement that its earlier monetary tightening measures were succeeding and “one measure of core inflation, the non-food non-energy CPI, continued its downtrend from 7.8 percent YoY high in October 2005, to 6.3 percent YoY at end-FY06, and to 5.1 percent YoY by the end of FY07.”

This rather benign and relaxed view of inflationary trends (even if food and energy are excluded) subsequently stood in marked contrast to the monthly trend from April 2007 to April 2008 as shown in the graph:

The problem goes beyond just the failure to anticipate. Pakistan is the only one among the major Asian countries whose inflation rate has been persistently higher than its GDP growth rate since 2005. The policy makers thought it was acceptable to have an inflation rate (CPI) of 7-8 per cent during 2005-2007 (see table below) when almost all Asian countries had inflation rate of four per cent or less and there was no oil or food crisis.

It is also a matter of record that the real interest rates in Pakistan continued to decline throughout 2006-2007 after reaching their peak in April 2006. This writer noted in the Dawn’s EBRW issue of January 22, 2007, “The real interest rates in Pakistan depict a declining trend since mid-2006 while those in India show an upward trend. Declining real interest rates can portend a higher inflationary environment 18 months down the road.”

It appears that despite modest increases in interest rates in 2005 and 2006, the State Bank’s monetary stance was quite accommodative to the consumption driven and liquidity fuelled economic policies of the previous government which failed to appreciate that around 8-9 per cent inflation rate was simply unacceptable and ran the risk of running into double digits in the event of supply or external shocks.

Now, the State Bank has cited the rapid deterioration in the budget deficit, recent widening of the external current account, pressure on the exchange rate, and increase in domestic lending as the key developments that led to the extraordinary monetary policy tightening measures. The reasons are valid and the monetary tightening is justified in principle but was the shock necessary? Let us examine some of these reasons.

The usual logic behind such a sharp increase is it would restrain the growth in credit demand and money supply. From July 2007 to May 10, 2008, the government’s net borrowings (for the budgetary support) from the entire banking system were Rs.362.1 billion and accounted for 98.7 per cent of the money creation or increase in the money supply (M2). As of May 19, 2008, the net government borrowings from SBP stood at Rs. 544.1 billion compared to the previous year’s level of Rs. 35.9 billion.

The stock of outstanding Market Related Treasury Bills (MRTBs), an instrument through which government borrows from SBP on tap for replenishment, reached Rs945.9 billion; highest ever in Pakistan’s history and more than double of last year’s level of Rs452.1 billion. These extremely high levels of government’s borrowings from the central bank lie at the heart of the problem.

The private sector credit grew by 19.9 per cent during July 2007 to May 10, 2008; compared to 15.9 per cent growth during the corresponding period last year. However, the increase in demand for working capital rose as (1) delays in the settlement of price differential claims led the independent power plants and the oil marketing companies to resort to financing from bank sources, and (2) a sharp surge in raw material prices, both in the domestic and global markets, pushed up the credit demand from the corporate sector. Other the data indicates a deceleration in growth in lending to the manufacturing and consumer sectors.

The bank’s contention that extraordinary growth in the non-oil and non-food imports represented import demand pressure during the first four months of 2008 may only be partially true because the increase in the imports of fertiliser and other chemicals (the largest group in non-oil and non-food imports) is largely due to the sharp increase in the international prices and not due to increase in demand which is fairly inelastic.

The reality is that the economy is slowing down and faces the prospect of stagflation in the wake of high global commodity prices and serious domestic imbalances. This year’s GDP growth estimate has been revised downwards to 5.7 per cent (which may still be overstated) given just 4.8 per cent growth in the large scale manufacturing sector and only 1.7 per cent growth in the agriculture sector. Private sector accounts for around 63 per cent of the total lending in the system and the rate increase together with other restrictive measures will hurt.

The recent upturn in prices is driven primarily by government’s deficit financing, supply side factors and rise in the energy costs. While a tight monetary policy is consistent with dampening inflationary expectations, the timing and size of the increase could be disruptive for the industry. It also indicates that the State Bank has been caught by surprise by the severity of the crisis which has been building up for over a year. Indian regulators have adopted a more gradualist approach. Its central bank in mid-April 2008 announced the raising of the cash reserve requirement (CRR) by 50 basis points to eight per cent, in two steps of 25 basis points with effect from April 26 and May 10. The CRR was last increased by 50 basis points to 7.5 per cent in November 2007, following similar hikes in August, April, and February and December 2006 to bring the cumulative increase to 300 basis points.

This brings us to the crucial question of the capacity of the bank to face the turbulence ahead. The administration of our monetary policy suffers from two fundamental flaws. The bank is not completely independent and the finance minister enjoys a clout (in real terms) that few finance ministers do in this day and age.

The board of governors consists of mostly political appointees and do not seem to add much value to its governance. The lack of complete autonomy has not allowed it to grow as a vibrant and strong institution with the capacity to face the challenges of an increasingly open economy.

While its decision making process appear to suffer from many flaws, here is a major one. Although the State Bank claims to monitor and review economic developments and its monetary stance regularly, the system is less than transparent. It makes its monetary policy statement only twice a year. If it conducts monthly meetings to review its monetary policy, it does not disclose this and does not publish its minutes.

The crisis may serve to reinforce the need to reform the system so that the State Bank is made completely independent with the government no longer able to borrow from it and its capacity strengthened to conduct its operations, including its core function of managing monetary policy, in a better and completely transparent manner.