ARTICLE (December 02 2008): "At the core of our dark experience lies the ugly truth that there was an absence of transparency, accountability, public interest, and public responsibility." Anand Panyarachun, former Prime Minister of Thailand.
The above quotation seems to be an apt description of the main causes of the present macroeconomic crisis our country, which hopefully would be tackled soon by implementing an appropriate stabilisation policy. The quotation also refers to the primary factors of good governance, which were absent then in Thailand and, sadly, still so in our country.
Without necessarily accepting, at the outset, the assertion in the last sentence, this paper presents an analysis with three-fold objectives. The first objective is to take a retrospective analysis of recent macroeconomic trends with a view to isolate the main economic factors responsible for rapid economic deterioration. Second objective is to link these factors with the quality of economic governance. Third objective is to draw some lessons for future improvement in economic governance necessary to propel our country into a sustainable path of growth and development.
I will first review in the following section, retrospectively, the recent macroeconomic events in terms of four inter-related sets of macroeconomic indicators pertaining to inflation, fiscal, monetary and external sectors. Before analysing the trends, lags in data compilation and availability should be kept in mind.
For example, presently (6 November 2008) we are in 2nd quarter of the fiscal year, but we do not know the size of fiscal deficit for the first quarter because the lag in compilation and release of fiscal data is at least two months. So we will know about the size of fiscal deficit of first quarter of FY09 next month (December 2008). In a retrospective analysis, this point becomes important and will be discussed later with reference to issues related to data timeliness and quality.
A RETROSPECTIVE ANALYSIS:
Table 1 presents a synopsis of inflation indicators during FY07 to Q1-FY09. The first thing to note is the sudden and ferocious onslaught of inflationary pressures from the 3rd quarter of FY08, which took the inflation from 8.8% in December 2007 to 23.9% in September 2008. In contrast, from FY05 till the 4th quarter of FY07, there was almost a continuous, though, sluggish decline in inflation on YoY basis.
Also, in the first two quarters of FY08, when inflation started to rise, it remained below 9% in terms of all indicators except food inflation. However, core inflation had reversed its declining trend from first quarter of FY08 and SBP tightened its monetary policy in July 2007 by increasing its policy rate from 9.5% to 10.0%, besides increasing its cash and statutory liquidity requirements. SBP again increased its policy rate by another 50 basis points to 10.5% at the end of January 2008.
It is clear from Table 1 that the rapidity in inflation was primarily due to rapid increases in food and commodity prices whose source was largely external. Once begun as food inflation, and irrespective of the source, there is always a risk of second round impacts through expectation formation and wage-price spiral. Hence, monetary tightening is always needed in such circumstances. The needed strength of tightening, however, depends on prevailing level of excess aggregate demand in the economy.
When MPS January-June 2008 was issued in January 2008, inflation data available at that time pertained to December 2007. None of the forecasts of inflation available at that time correctly anticipated the strength of inflation that actually materialised for FY08 and beyond. SBP projections for FY08 made at end December 2007 indicated a range of 6.5% - 7.5% for inflation and 13.5% - 14.5% for broad money growth.
This projection for inflation proved to be widely off the actual observed average CPI inflation for FY08 which was 12.0%. In retrospect, it is easy to criticise SBP for not anticipating the strength of inflation. It is also now a common criticism by economic/financial journalists that whatever SBP did in terms of tightening monetary policy "it was too little and too late".
SBP welcomes all these criticisms; this is perhaps a firm indication that monetary policy transparency is increasing. Although there is still a considerable room for strengthening the mechanism of monetary policy formulation and implementation, the current set-up despite its weaknesses, enabled SBP to come up with periodic policy responses which it considered appropriate.
Hence, there was no absence of "public responsibility" (mentioned in the quotation) as far as actions of SBP are concerned. The strength of policy responses by SBP were, in fact, considerably more than its present level of independence allowed. I will revert to this central issue of governance in the later section.
Table 2 presents a summary of fiscal indicators during FY07 and FY08. We have already seen that extraordinary inflationary pressures started to develop from 3rd quarter of FY08. This was preceded by extraordinary pressures on fiscal account that is clearly visible in fiscal deficit to GDP ratio that increased to 1.5% (6.0%; annualised basis) in the first quarter of FY08.
Also note that this information became publicly available in end November 2007, along with other details of quarterly fiscal operations released by the Ministry of Finance in their website. These developments prompted SBP to write the following in its first quarterly report for FY08 sent to the Parliament on 5th January 2008:
"All key fiscal performance indicators deteriorated significantly in Q1-FY08 ... if current trends persist and strong corrective measures are not undertaken promptly, the annual fiscal deficit target of 4.0 percent of GDP for FY08 will not be met."
Fiscal stress continued to increase as is apparent from indicators in Table 2. While the deterioration was visible in all fiscal indicators, it was impossible to pinpoint it on subsidies because of the opaqueness of quarterly fiscal details of subsidies. Quarterly amounts of subsidies used to be disclosed in MOF website till 2004, but since 2005, subsidy amounts were disclosed only in annual budget statements.
Simply put, while annual fiscal data is relatively transparent, quarterly data is comparatively less transparent and opaque regarding subsidies. While the story regarding subsidies became known to public by the disclosure made by Ishaq Dar (then Finance Minister) on April 9, 2008, I will confine myself to only a few points visible in Table 2.
Annual size of the subsidies became 3.6% of GDP; 2.6 percentage points more than FY07. Interest payments became 4.7% of GDP; 0.5 percentage points more than the level in FY07. These two heads produced the major stress in fiscal operations in FY08. Also the bulk of subsidies were booked in the budget in 4th quarter of FY08. The last observation is apparent from the fact that 4th quarter non-interest expenditure (including subsidies) jumped significantly from its past trend.
While the size of the budget deficit alone indicates the severity of macroeconomic imbalance, its financing mix is of utmost concern not only to a central bank but to the public at large and for upholding the "public interest" (mentioned in quotation).
When deficit is being financed primarily from central bank borrowing, this is almost a sure sign of the onslaught of high inflation. In fact, if fiscal dominance of this high order continues, risks to very high and hyperinflation will soon compound. In FY08, 89% of the budget was financed by borrowing from SBP.
In fiscal data released by MoF, this composition of budget financing is opaque. Fiscal disclosure conveniently hides this under a head "Bank" which actually means the banking system that includes both the SBP and all scheduled banks. This opaqueness, however, is somewhat diluted by the weekly disclosure of monetary survey on the website of SBP that separately mentions government borrowings for budgetary support from SBP as well as scheduled banks.
Table 3 presents a summary of monetary indicators during FY07 to Q1-FY09. In the presence of fiscal dominance described earlier, together with a situation of depleting reserves, there is a greater need to exercise caution in interpreting various monetary indicators. For example, broad money growth at the end of first quarter of FY09 seemed rather benign at 13.5%.
This is not a correct conclusion. Since broad money is a sum of domestic credit (net domestic assets) and the net foreign assets of the banking system, continuous depletion in one factor (especially NFA) is the main cause of monetary and financial stress. I would have labelled the growth in M2 of 13.5% as within safe limits only under normal conditions of accumulation of reserves.
In fact, this composition of money supply is clearly revealing the main symptom of macroeconomic imbalance that is caused by high budget spending financed mainly from the inflationary borrowing from SBP.
It is precisely this spending that has aggravated the demand pressures in the economy to create the classic problem of twin deficits. Both the budget and current account deficits have far surpassed their sustainable limits; hence the pressure on reserves to deplete and rupee to depreciate.
More meaningful monetary indicators, in the current situation, are the growth in domestic credit (NDA), growth in reserve money, depletion rate in NFA and the size and growth in inflationary borrowing from SBP. FY08 flow of credit to GOP directly from SBP was to the tune of 6.6% of GDP, with outstanding stock at 9.9% of GDP.
This flow has not stopped in FY09, in spite of assurances by MoF about keeping these borrowings at zero. First quarter FY09 borrowing flow stands at 1.8% of GDP, with stock at 10.3% of GDP.
These numbers, unfortunately, hardly require any interpretation. Pure and simple, this is a balance of payments crisis, which we can tell without even looking at the data through its connection with net foreign assets to monetary data.
Table 4 presents selected indicators on external sector during FY07 to Q1-FY09. High import growth, which is causing the reserves depletion, was in fact driven by all categories of imports, and not just by oil, although oil import bill has caused the major stress. The first thing to note is about non-food non-oil imports. Their growth was brought down to just 4.0% in FY07 because of tight monetary policy, which was not destroyed by the inflationary borrowings of GOP then.
Import growth runs amok as soon as GOP went on a binge of inflationary borrowings from SBP in FY08. Year on year growth in non-food non-oil imports went as high as 42.4% in 3rd quarter of FY08, and started receding due to the depleting reserves and correction in exchange rate. This growth has come down to 14.6% in the first quarter of FY09, but is still very high.
Stress caused by oil import bill is too obvious. What is not obvious is that an earlier fiscal response of passing on oil price increase to consumers would have influenced them adjust their oil consumption. The notion that oil demand is inelastic and would not have made any dent in consumption can safely be rejected; elasticity would have been low but significantly different from zero.
What this implies is that a complete lack of a fiscal policy response in the earlier period of external price shock created severe difficulties not only for the fiscal sector, but monetary and external sectors as well, besides worsening the inflationary pressures. A timely fiscal response could have mitigated the stress on balance of payments, or lessened the speed of depletion of reserves.
An obvious question here rises about the exchange rate regime and the appropriate policy response by SBP. Exchange rate regime (fixed, managed, floating, etc) is always decided by the government. Once decided at government level, day-to-day exchange rate management lies with the central bank.
Here, the institutional arrangement is much more vague than the obviously flawed financing arrangement between SBP and MOF discussed earlier. I attempt to summarise this dangerous vagueness regarding exchange rate regime and its implementation here by briefly recalling past history.
During the last balance of payments crisis, triggered by nuclear detonation in 1998, a dual exchange rate regime was adopted by GOP and implemented by SBP. Later on, this regime was unified in May 1999 to become a free float. With ensuing pressure on exchange rate, a de facto cap was placed on dejure float. Later, it was also lifted to become a free float during July 2000.
Exchange rate again came under pressure in end 2004. To stabilise the exchange rate, a novel way of intervention was adopted, presumably, at the behest of then finance minister. Under this unique system, full "market support" for meeting oil import bill was provided to foreign exchange market. This strategy immediately quelled all speculative pressures in foreign exchange market.
Not surprisingly, free float became almost a fixed exchange rate regime. Since, it was not a dejure peg, it was classified separately by IMF as a de facto peg! This was a clever strategy suitable for that time; stable exchange rate proved very conducive in attracting FDI and portfolio flows.
Given a perennial and unified national obsession with maintaining the value of Rupee (against whatever odds) it was almost completely forgotten that this obsession is actually a deadly mirage. During the tenure of the present Governor, the proposal of gradually withdrawing "market support" for meeting import payments was taken up in the Monetary and Fiscal Policies Co-ordination Board, but the decision was to largely keep the irrational market support policy intact.
The above retrospective description about exchange rate regime is extremely important. While the SBP policy of providing "market support" was fully transparent, even the best and brightest of economists and financial analysts have criticised SBP only about the interest rate stance but seldom about the exchange rate misalignment, which was a main cause of distortion, along with fiscal indiscipline and dominance.
