Injudicious monetary policy
THE Monthly Economic Updates and Outlook released by the Ministry of Finance for March 2023 reveal some extremely alarming facts. The document reveals that the markup expenditure during the first seven months of the current fiscal year increased by 73% compared to the similar period of last year. The markup expenditures for last fiscal year were recorded to be 3143 billion, and if the trend continues, by the end of this fiscal year the markup expenditure will reach about 5440 billion. The budgetary allocation for this head was 3950 billion the government has to spend about 1500 billion above the original allocation. The original allocation for markup payment was 2.5 multiples of the defense budget, the second largest head in the federal budget, and with this surplus spending on markup, the total markup expenditure will reach 3.5 multiples of the defense budget.
In contrast, the non-markup expenditures during the current fiscal year were reduced by 26%. The non-markup expenditures for the previous year were 5388 billion and if the trend continues, this fiscal year will end with non-markup expenditures of 3980 billion. The ratio of non-markup to markup expenditures for the previous year was 64:36 which will change to 42:58 if the trend continues. This means 42% of the Federal budget would be consumed for entire functions of the government including salaries of employees, subsidies, pensions, defense budget and the grants for the provinces. On the other hand, 58% of the budget would be consumed only to pay the markup expenditures on the domestic and foreign debt with 85% to be consumed for domestic debt. It is pertinent to note that the domestic debt during the past 1 year increased roughly by about 18%, but the markup payments increased by 73%. The reason for this disproportionate increase in the markup is the increase in policy rate. When the present government took charge, the policy rate was 13.75% which is now jacked up to 21%. The markup on government debt also increased accordingly.
The Monetary Policy Statements mention inflation as the main reason for hike in policy rate, but actually this rise was ordered by the IMF. Both the IMF and State Bank think that the high interest rate can reduce inflation. However, the historical data from Pakistan and from other parts of the world strictly opposes this proposition. For example, since January 2022, the interest rate in the United States has increased from 0.25% to 5% with the explicit aim of controlling inflation. Despite this increase, the inflation in the US today is roughly double of the level January 2022. There are similar stories for the United Kingdom, European Union and many other countries. All of these failed to reduce inflation despite huge increases in the interest rates. The hike in interest rate can control inflation only when the inflation is due to demand side factors but the current inflation is very clearly supply sided which can never be controlled by interest rate hike.
The hike in interest rate is responsible for many other negative consequences. As we mentioned, the markup payments increased very rapidly because of this hike. This hike will increase the fiscal deficit and the government will face pressure to reduce the deficit by increasing the tax revenue which will lead to further hike in inflation. Similarly, the hike in policy rate means the loans for the producers have become expensive, which will increase the cost of production leading to higher inflation. It is well documented in the academic and policy literature that when the inflation is supply-sided, the increase in interest rate would be counterproductive i.e. it will increase inflation instead of reducing it. However, the central banks and international financial institutions badly ignore this fact, and destroy the economies of vulnerable countries like Pakistan by overemphasizing the interest rate hike.
The high interest rate makes loans inaccessible for the small businessesand startups which badly affects the employment. Such a huge allocation of markup payments goes into the pockets of few banks and their depositors who have big deposits, therefore the hike also leads to increased income inequality. Ignoring all these negative consequences, the State Bank is blindly following the inflation targeting imposed by the IMF, and this policy is hurting the welfare as well as security of the country. It would be pertinent to note that the budgetary allocation for the defense increased only by 56% during the past 5 years, whereas the allocation for markup payments increased by 256% during the same period. The markup expenditures are protected by the shield of the IMF and no one goes to discuss the effect of hike in markup payments. The burden of covering the fiscal deficit will fall on the defense budget, the second highest budget head, and there will be pressure to reduce the defense budget. In fact, the real value of the defense budget has continuously declined during the past 5 years and now it’s possible to have a cut in its nominal value as well.
In the presence of a hostile enemy on a long eastern border with a defense budget of about over $70 billion, a further cut in the defense budget would be a big threat for the security. In fact, the only plausible way to reduce the fiscal deficit is to reduce the policy rate which will lead to reduction in markup payments. But such a move will make the IMF unhappy and the next tranche of the IMF package will be at stake, therefore, the government and State Bank are blindly following the orders of IMF putting the security and welfare of the state at a serious risk. The cost of a hike in policy rate is in trillions, and this is justified as a tool to control inflation. But very surprisingly, there is no single evaluation rate on the effectiveness of monetary policy. It is time to ask SBP to present the evidence of the effectiveness of monetary policy. If it is not present, the hike must be reversed to improve fiscal balance, to find fiscal space for functions of government and to reduce pressure from defense budget.
—The writer is Director, Kashmir Institute of
Economics, Azad Jammu and Kashmir University.
Email: [email protected]
