Monetary Policy in Pakistan

– Evolution
Dr. Syed Ateeb Akhter Shah
Institute of Business Administration, Karachi
September 29, 2024 – Online Make-up Class
Who conducts Monetary Policy in Pakistan?
• The making and conduct (operation) of monetary policy in Pakistan is the responsibility
of the State Bank of Pakistan (SBP).
• In coordination with:
• Fiscal Policy
• The State Bank of Pakistan Act, 1956 defines “ WHEREAS it is necessary to provide for
the constitution of State Bank to achieve domestic price stability by way of regulating
the monetary and credit system of Pakistan and, without prejudice to said primary
objective, contribute to the stability of the financial system of Pakistan and supporting
the general economic policies of the Federal Government to foster development and
fuller utilization of the country’s productive resources; ”
• “ “price stability” means the maintenance of low and stable inflation guided by the
government’s medium-term inflation target ”
• Triple Mandate: Price Stability, Financial Stability and Economic Development
What can the monetary policy do?
• It is widely believed that the monetary policy can address the demand side issues by
managing the flow of money and credit in the economy.
• However, this view has been challenged several times and the literature found that the
expectations channel allows a central bank to anchor inflation expectations that may
arise due to supply-side shocks such as floods, high international commodity prices, etc.
• Demand Management – Episodes from history:
• In Pakistan insufficiency of aggregate demand was observed in the 1990s, which is to
economists “lost decade for Pakistan” – resulted in unemployment
• In contrast, excess demand can bring inflation, evident from double-digit inflation episode of
FY2008 – FY2012.
Monetary Policy Regimes in Pakistan
• At the time of independence, like other central banks of the world post World War II,
SBP followed Monetarism to attain price stability.
• Monetarism is a view that monetary policy is a prime source of the business cycle, and a
constant monetary growth rule can be followed as an attempt to smooth out the
fluctuations in output growth.
• If a stable relationship exists between monetary aggregates and inflation, a central bank
can achieve price stability by monetary aggregate targeting.
1. Monetary Aggregate Targeting
• SBP targeted M2 growth within desirable limits, the target for M2 growth were estimated
using money demand function considering Government’s annual economic growth and
inflation targets for the year.
• M0 (Reserve Money) has been the operational target
• M2 growth (intermediate target)
• Following “Reserve Money Program” SBP conducted desired level of OMOs.
• Financial sector advances significantly weakened the relation between money and inflation
[Moinuddin (2007), Hanif et al (2010)]
• SBP used to get detailed credit plans for the year from National Credit Consultative Council,
which was later renamed Private Advisory Committee. It then started providing indicative M2
targets based on growth and inflation targets announced by the Government.
• Since FY2010, SBP abandoned target announcement for M2 growth.
2. Interest Rate Corridor
• The operational target was changed from Reserve Money to Overnight Weighted Average
Repurchase rate (WAREPO) in January 2009 Hanif (2014), August 2009 Asif (2016). I
believe it does not matter when! It is the interest rate that is the operational target now!!!
• The conventional tools were also in place: OMOs to restrict movement of WREPO
within the corridor, discount rate, cash and statutory reserve requirements, subsidized
credit schemes such as Long-Term Financing Facility (LFTT) (mainly for large capital
equipment) and Export Refinance Scheme (EFS) (to support exporters), etc.
• The volatility in the short-term interest rates does affect volatility in the long-term
interest rates on Government securities, the yield-curve.
• Monetary conditions indicators are observed, such as different measures of inflation
(Headline, Core, Energy) at the rural and urban level, proxy for output gap, balance of
payments, exchange rate, etc. A combination may also be closely monitored, which fall
under monetary/financial conditions of the economy.
• Many do not know of the name of this regime: It is called Inflation-Targeting Lite
Regime
Monetary Policy Experience of Pakistan –
Short Synopsis
• Inflation in Pakistan has been roughly equal to the rate of board money growth minus
real output growth, which simply means Inflation in Pakistan has been a monetary
phenomenon.
• Since its independence Pakistan has been in difficult position, therefore, SBP had to
manage the availability of credit to generate economic activity and regulate price of
credit for more than half of its independent life.
• In the early decades, Government provided credit at subsidized rates. This did not bode
well, as it posed challenges for price stability and adversely affected production and
supply side of the economy Janjua (2004).
• To ensure a sound and efficient banking system, reforms were undertaken in 1972.
Aiming purposeful and equitable distribution of credit, National Credit Consultative
Council was established in 1972. This was to enhance allocative efficiency of the credit.
Monetary Policy Experience of Pakistan –
Short Synopsis (continued)
• This body met bi-annually to access Government and private sector credit needs, based
on fiscal situation, and set credit target for both entities (Govt. and Private).
• Mandatory allocation of bank’s credit at subsidized rates to priority sectors, irrespective
of their economic efficiency distorted smooth functioning of the market and undermined
the strength of the financial system. As a result, inflation quadrupled in 1970s as
compared to 1950 – 1970.
• The 1951 – 1970 average inflation of 3.1% never came back even though a strong
attempt was made in 1980 to control inflation. The average of 1971 – 2010 is 9.5%.
• Although, the size of the bank credit was very small as a percentage of GDP. SBP still
used interest rates at some instances to defend the exchange rate.
Monetary Policy Experience of Pakistan – Short
Synopsis – Financial Sector Reforms of 1990s
• In 1990s supervised by effective legal/judicial system, allocation of resources in response to
price signals than vested interest was undertaken. This was to turn the economy into a
predominantly private system, where decisions are motivated by incentives.
• Effective February 1992, SBP has been signaling its stance mainly using policy rate than other
measures of monetary management.
• SBP tracks 12-month moving average year on year inflation, which reduces/eliminates noise
pertaining to the seasonal patterns in price level.
• Long-term inflation was monitored through 36-month moving average, this is observed after
February 1992. The SBP policy rate changes were broadly made according to change in trend
inflation as measured by a 36-month moving average of the headline inflation, though never
stated explicitly by SBP.
• The reforms made transition from administrative controls to quantitative restrictions to market-
based instruments.
Monetary Policy Experience of Pakistan – Short
Synopsis – Financial Sector Reforms of 1990s
(continued)
• Credit ceiling for commercial banks as an instrument of credit control was abolished with effect
from (wef) August 1992. Replaced with Credit-Deposit Ratio but it was also abolished in
September 1995. Thus, market forces decided allocation of private credit.
• 3-day reverse repo facility was introduced for short-term liquidity injections. A policy rate
minus 2.5% repo facility for parking excess reserves was also introduced.
• OMO became the major monetary policy instrument. M2 growth targets were achieved through
control on reserve money.
• Post July 2000, SBP was required to only intervene in the foreign exchange market if needed.
However, this practice is not fully followed.
• Interest rate restructuring was undertaken, and the first auction of the government system was
done in March 1991. A 6-month treasury bill was sold through auction then.
• For a long-term interest rate and forming of a yield curve to provide pricing benchmark for the
private sector securities, Pakistan investment bond was launched in December 2000.
Monetary Policy Experience of Pakistan – Short
Synopsis – Financial Sector Reforms of 1990s
(continued)
• SBP transferred 6-month treasury bill cut-off rates to ministry of finance, thus separated
monetary management from debt management.
• Restrictions on bank’s max lending except concessionary schemes were remove in 1995.
Minimum lending rate was abolished in July 1997.
• From June 1998, SBP allowed banks and other financial institutions to determine their own
deposit rates
• This allowed SBP to use the credit channel of monetary policy transmission effectively.
• Effective 1993, reserve requirements on banks was also not required to be approved by the
Government.
• Monetary policy post financial sector reform has been mostly done by OMOs as the main
instrument.