Monetary Policy of State Bank and Pakistan Economy
Monetary Policy of State Bank of Pakistan: a Review and Impact Analysis
By: Irfan Karim
Monetary policy of any country involves various tools to influence interest rates in the banking and financial markets and/or money supply in an economy with the objective to achieve stability in inflation and to support economic growth. State Bank of Pakistan Act, 1956 empowers the central bank to frame monetary policy to secure financial stability and to attain better utilization of economy’s productive resources.
State Bank of Pakistan issues Monetary Policy every 6-8 weeks after a committee of experts (Monetary Policy Committee) carries out review of economic data and prevailing trends. Latest Monetary Policy Statement (MPS) was issued in September, 2023 with a key decision to continue with existing Policy Rate of 22%. Considering the prevailing extraordinary economic challenges sine the last one year or so, MPS carries special importance and has been analyzed by students and researches alike.
This blog endeavors to explain in rather simple words, about
the objectives behind Monetary Policy decisions and various Monetary management
tools applied by central banks. Impacts of
such policy decisions on the economy and business have also been discussed.
Monetary
Management by Central Banks
Definition
of Monetary Management
Monetary
management in a country generally means the
measuring and managing of circulation/
demand of money in the economy and regulating the flow of credit and bank
loans. The purpose of such management may include:
·
To control inflation
·
Preserving foreign exchange reserves
·
To Ensure stability in payment systems and
banking flows
·
and supporting private investments.
Monetary Policy and Tools
Central banks (State Bank of Pakistan in case
of Pakistan) exercise Monetary Management by analyzing prevailing trends of
economic data and flow of money within the banking sector, financial
markets and in the external front (import/exports/foreign remittances etc.).
State Bank of Pakistan (SBP), on the basis of the such analysis, issues Monetary Policy for the country after every 6 to 8 weeks. Within the powers vested vide SBP Act 1956, State Bank of Pakistan issues policy decisions and directives for implementation within the banking sector and financial markets.
Monetary Policy decision may apply following
tools to achieve the objective of stabilizing the financial system:
SBP Policy Rate determines the Discount Rate, at which it may lend money to other banks as lender of the last resort. This discount rate is linked to a base Policy Rate announced in each Monetary Policy. The Policy Rate further drives fluctuation/changes in the market interest rates. Thus cost of borrowing money for consumers and businesses, as well as the return on bank-deposits are also influenced after announcement of Monetary Policy.
Depending upon the economic trends, Monetary Policy Statement may announce an upward or downward change in existing Policy Rate.
Policy Rate may also be referred to as Base Rate of the financial system. The Policy Rate adjustment is used to manage inflation or to support trend of economic growth.
Rationale behind Adjustment in Policy Interest Rate
Under high inflation scenario, Policy Rate is increased so that bank’s loan prices move upwards and demand for credit may be brought down. After a certain time period, once inflation is reduced to a reasonable level, Policy Rate are gradually be reversed/reduced in the successive Monetary Policies to bring down the cost of bank-credit.
Generally, lower interest rates encourage people to save less and consume or invest more, and vice versa.
Following is the last three years trend of respective MPS decisions of State Bank of Pakistan:
Pakistan Economy: Three years History of Policy Rates
|
Monetary Policy Period |
Policy
Rate |
|
Jan 2020 |
13.25% |
|
March 2020 |
12.5% |
|
March 2020 |
11% |
|
April 2020 |
9% |
|
May 2020 |
8% |
|
June 2020 |
7% |
|
Sept 2020 |
7.25% |
|
Nov 2021 |
8.75% |
|
Dec 2021 |
9.75% |
|
April 2022 |
12.25% |
|
May 2022 |
13.75% |
|
July 2022 |
15% |
|
Nov 2022 |
16% |
|
June 2023 |
22% |
During 2023, Policy rate has been increased to high levels in successive Monetary Policies to counter extraordinary high inflation rates and volatile exchange rates in Pakistan during the last year or so.
Next Monetary Policy review is scheduled at the end of October 2023.
b) Adjustment in Ratios of Cash Reserve Requirement and Statutory Liquidity Reserve
SBP as a part of its monetary management tools
asks every bank and financial institution to transfer a certain portion of its deposits to a reserve
account with SBP. This mandatory deposit is implemented under Cash Reserve
Requirement (CRR) of State Bank of Pakistan, which is measured and monitored on
daily and weekly basis. Each bank and
financial institution is required to maintain a certain ratio of CRR with SBP account;
the ratio of CRR may be adjusted or announced in Monetary Policy statement or
through circulars if deemed necessary.
This monetary management tool may be applied by
SBP when it considers that overall banks deposits have increased in much higher
proportion than the real demand for credit and the banks are sitting on excess
liquidity. This scenario, if remain unchecked, may lead to higher inflation in future. SBP
may therefore increases the CRR and banks will be obliged to deposit more funds
in reserve account.
Similarly, SBP may also apply SLR tool
(Statutory Liquidity Reserve) whereby banks/financial institutions are required
to invest a certain percentage of the deposited funds in government securities.
c) c) Injection of Funds or Mop-up of Funds from
Inter-Bank Money Market
These are more frequent operations (could be on
weekly or fortnightly basis) to stabilize flow of money in the banking
system. Depending upon the supply of funds to the banks and demand of
credit there against, SBP may estimates future needs of the banking system and
accordingly inject funds from its reserve account or otherwise announce mop-up
of excess liquidity.
Injection of funds is carried out in the form
of lending by SBP to Banks/ financial institutions, for specified days, at a
rate close to Policy Rate.
Conversely, Mop-up of excess funds means SBP
borrows from banks/financial institutions for a specified time at a price,
close to Policy Rate.
d) d) Management
of Foreign Exchange Reserves
The above referred tools/instruments of Monetary Policy are closely linked to inflows and outflows on account of foreign exchange transactions. Pakistan receives foreign inflows from exports, foreign investments, workers remittances from Pakistanis living abroad and government receipts. On the other hand, these funds are utilized to meet import bills, debt servicing and other USD denominated outflows.
With the objective of meeting such payments and to maintain foreign exchange reserves at a reasonable level, sources of foreign currencies and buying-selling is closely monitored. Based on the foreign exchange requirements and country’s commitments, SBP may issue instructions in the form of circulars to announce measures and curbs to control foreign exchange reserves; or otherwise announce facilitation measures to promote trade and business transactions. Above referred Monetary Policy tools may be applied to strike a balance between stable local currency management and foreign currency reserves.
Current Monetary Policy and Its likely Impacts
Pakistan economy is currently faced with a
multi-faced challenges. Slow-down of global economies and lingering impacts of
post-Covid shocks have resulted in extremely high inflation, reduction in local
produce and foreign direct investment and falling foreign remittances etc. Last year floods and drop in agriculture produce have further fueled the rising
inflation. In such a scenario, Monetary Policy Committee has used the tool of
Policy Rate hike for a number of times since 2021-23 to keep the inflation rate
under check.
The successive Monetary Policy decisions of monetary tightening are aimed at limiting the rising trends of inflation and exchange rate volatility and help Pakistan economy to regain strength so that inflation and exchange rate do not reach to uncontrollable levels.
However there are costs attached to the policy of monetary tightening. Following could be likely impacts of high policy rates on Pakistan economy:
|
Positive
Impacts as Envisaged in MPS |
Immediate Costs/Impacts on Economy |
|
Increase in Policy rate and monetary tightening
will result in reduction in inflation rate, though with a lag. |
High Policy rate affects all other
market rates. Therefore banks loans for industry and trade will become more
expensive. |
|
High interest rates will encourage savings and minimize
depreciation of currency value. However there are other competing market forces that may have their own adverse impacts and therefore hinder progress on this front. |
Benefit for the depositors due to higher profit rates on deposits/National Saving Schemes, while cost of new
deposit for banks/ institutions will increase and their profits could be adversely impacted . |
|
Once inflation is controlled at a reasonable
level, economic growth will pick up in the form of new business and investments over time. |
Higher cost of bank loans will lead to lesser
credit demand and lower economic activity. Exorbitantly high interest rates may lead to closure of weak businesses in the
short term, high risks of unemployment and default of expensive bank loans.
|
The positive impacts are absorbed by the economy in a gradual manner.
Government borrows huge funds on commercial rates from banking sector. With increase in Policy Rate banks are now providing funds to government at a yield of 22% and above. So debt servicing cost of the government will increase with increase in Policy Rate.
· How Consistent Fiscal Policy is Significant for achieving Monetary Policy Targets
Monetary
Policy is framed independently by State Bank of Pakistan. However, its domain and area of impact is limited to
commercial banks, financial markets and policy rate environment. The remaining
areas that impact the whole economy are driven by Fiscal policy and decisions of the government regarding growth of
Pakistan economy.
Fiscal
Policy relates to collection of taxes, new loans raised by governments and
repayments of existing ones, expenditures by the governments, announcement
of development schemes involving large outlays etc. These are beyond the scope
of Monetary Policy.
For fully achieving the targets set in the Monetary Policy and the desired stability in the economy as a whole, consistency in the decisions and directions of both fiscal policies and monetary policies are significantly important. Coherent policies may lead to better control on inflation, stable exchange rate, followed by growth in business and economy.
While
reiterating this fiscal-monetary policy consistency factor in MPS of January
2023, the Monetary Policy further concluded as follows:
Read More: Pakistan National Debt and How Pakistan Economy can Avoid Sovereign Default
Read More: Bloomberg also Acknowledges Pakistan Progress towards Repayments of Debt
Comments
Post a Comment