The monetary and fiscal quagmire

The Ministry of Finance, State Bank of Pakistan and IMF would like us to believe that fiscal consolidation has taken place, a prudent monetary policy has resulted in sound monetary developments and the country’s banking system is performing its financial intermediation functions on a solid footing.
Here I try to undertake a critical review of the monetary aggregates as on March 20, 2015 – the latest data released by the SBP on March 31 – to examine the true state of the fiscal and monetary situation emerging from monetary statistics and the consolidated balance sheet of the banking system.
The monetary aggregates show that money supply increased by 4.7 percent during July1, 2014-March 20, 2015 as compared with 5.5 percent in the same period last year. As the contractionary impact of the rupee counterpart of the Saudi grant, releases of CSF by the US and massive government borrowing from foreign private markets on the monetary aggregates has begun to wear out, money supply has recently accelerated to catch up with that of last year. In fact, the absolute increase in money supply up to March 20, 2015 is about the same as last year but the percentage growth is slightly lower due to a larger outstanding stock of money on whose basis the growth rate has to be computed.
Money supply went up by 12.5 percent in FY14 as a whole from only 5.5 percent in the first nine months of the year. In other words, the bulk of the growth in money supply took place in the last quarter of FY14. If the same pattern is maintained in the last quarter of FY15, money supply in FY15 may also be equally excessive. If anything, with the withering away of the impact of Saudi and US grants and borrowing from foreign private markets, the larger defence expenditure, the spending on mega projects and pressure for clearance of tax refunds held back to show a better revenue performance to the IMF, the growth in money supply in FY15 may exceed that in FY14. What makes the SBP and the IMF declare that a prudent monetary policy is being pursued is hard to understand.
Let us move on to the fiscal situation as reflected in the monetary aggregates. The net government borrowing from the banking system amounted to Rs.454 billion up to March 20, 2015 in the current fiscal year compared with Rs427 billion in the same period last year. In other words, notwithstanding the proclamations of the IMF, monetary statistics show no fiscal consolidation in FY15 as compared to last year.
There is, however, a profound change in the composition of government borrowing from the banking system. The government retired Rs587 billion to the SBP up to March 20 in FY15 as against net borrowing of Rs680 billion in the same period last year. Normally, a fall in borrowing from the central bank is a good thing because creation of high-powered money to meet the credit demand of the government is potentially very inflationary and destabilising. It would have been a welcome development if the change were to reflect a consolidation of the fiscal situation; however, it does not because the situation in Pakistan differs in three important ways.
First, the fall in borrowing from the SBP does not represent an improvement in the fiscal situation. It has happened because the government decided to substitute borrowing from the SBP by borrowing from commercial banks to meet the IMF conditionally on the net domestic assets of the SBP. Last year, the government had retired Rs118 billions of credit from commercial banks up to March 21, 2014. In the same period in FY15, the government has borrowed an additional amount of Rs1,097 billion. Thus, the overall amount of borrowing from the banking system has gone up in FY15 compared to last year.
Second, the massive increase in government borrowing from commercial banks has not been financed by commensurate effort by banks to mobilise deposits. The bulk of it has been financed by commercial bank borrowing from the SBP through its discount window or voluntary injection of liquidity in the commercial banking system through open market operations by the SBP.
The accommodative policy of the SBP in providing limitless financing to commercial banks to enable them to meet the credit requirements of the government blurs the distinction between government borrowing from the SBP and that from commercial banks in terms of its monetary, price and balance of payments effects. But the Ministry of Finance has been able to satisfy the IMF conditionality and the SBP fools the people by propagating that it reflects pursuit of a prudent monetary policy.
Third, this switchover has proven disastrous for economic activities in the private sector. The unlimited appetite of the government to borrow resulted in commercial banks ignoring the credit needs of the private sector. Credit to the private sector expanded by only Rs178 billion in the period up to March 20 in FY15 as compared to Rs367 billion in the same period last year. Thus, the government crowded out of the credit market the private sector, which figuratively is the goose that lays the golden egg. There are other intriguing aspects of the consolidated balance sheet of the banking system but those are being ignored here due to space constraints.
This brings us to the final topic of the impact of excessive government borrowing from commercial banks on the profitability and stability of the banking system and its fulfilment of financial intermediation responsibilities. The profitability data of commercial banks shows that they are minting money without playing their real role of financial intermediation and the SBP is watching all this as a disinterested party.
Commercial banks are supposed to mobilise private savings and use them to finance the credit requirements of the private sector and in the process make reasonable profits based more on expansion of the banking business than on an unreasonably high interest spread.
The unbridled government borrowing from commercial banks and open market operations by the SBP to bolster their liquidity enables commercial banks to earn ‘rental’ income without mobilisation of deposits and without meeting the credit requirements of the private sector. At the same time, the asset portfolio of commercial banks is dominated by treasury bills and bonds. The best banking practices require diversification of the asset portfolio of commercial banks and a limit on exposure of banks to a single party even if it happens to be the government. At present government securities account for close to 85 percent of the total assets of commercial banks.
The situation looks alarming when studied in the context of the rising domestic government debt. The fiscal situation is such that debt servicing and defence expenditure consume almost all the tax revenue and it is bound to rise at a faster pace than revenue without tax reforms. In the circumstances, the risk of default of sovereign debt has increased and so has the vulnerability of banks in case a fiscal crisis develops.
If the government were to print notes excessively to meet its debt servicing obligations to commercial banks, such irresponsible conduct is bound to lead to a loss of trust of the people in the currency of the country. The Ministry of Finance and the SBP should do some serious rethinking for course correction before they, intentionally or unintentionally, plunge the country in another economic crisis emanating from the domestic banking system.
The writer is a former governor of the State Bank of Pakistan.
Email: doctoryaqub@hotmail.com