NationalVOLUME 16 ISSUE # 22

SBP REPORT: THE NEXUS BETWEEN RISING INFLATION AND POLICY RATE

The State Bank of Pakistan recently released its second quarterly report on the state of the economy in Pakistan. The report devotes a whole chapter to fiscal policy and public debt. According to the SBP, the primary balance recorded a higher surplus during H1-FY21. The primary budget means the budget excluding the debt intake and debt servicing, and the surplus in the primary balance means the government has collected more revenue than it consumed.

It may be added here that the primary budget had recorded a surplus last year also, yet the federal budget had an overall deficit of 8.1% of the GDP. The budget deficit in the first half of FY21 has been 2.5%. A deficit in the overall budget despite a surplus in the primary budget means that the deficit occurred only due to markup payments. There was no debt repayment in FY 21, because the allocation for domestic and foreign debt repayment was zero, and the huge deficit existed because of the markup payments.

The coronavirus pandemic created problems for all countries. Many countries reported high deficits during 2020. The UK recorded a deficit of 2.6% during 2019, and 16.9% in 2020. Canada had a deficit of 1.5% during 2019, which increased to 16% in 2020. The extraordinarily large deficits in developed and developing countries occurred due to epidemic-related spending. Most countries offered relief packages to ease the hardship of their people. The UK and Canada spent 18% and 19% of their GDPs respectively on Covid relief. The relief package announced by the government of Pakistan was about 2.6% of GDP, as compared to 8.1% of the deficit.

It is necessary to mention here that the existing social spending programmes, like BISP, and pending government liabilities were also factored in the Covid relief packages. The surplus primary budget achieved during the pandemic indicates a reduction in real government spending. But the budget showed a deficit because of the markup payments.

Figures show that even the meager funds allocated for the Covid relief package could not be fully utilised. The Covid-related spending other than the Ehsaas programme during the 10 months of the current fiscal year is said to be only 27% of the funds allocated for the purpose. This is what has led to the primary surplus; but it was more than offset by high markup payments, resulting in a huge overall deficit.

According to experts, the government’s high markup payments have been due to the choice of policy rate. Countries having much higher debts are consuming much less on the markup payments. For example, the public debt in the United States exceeded 129% of their GDP in 2020. For this huge amount of debt, the markup payments constitute about 1% of their GDP. In Pakistan, the debt-to-GDP ratio is less than 100%, yet the markup payments exceeded 8% of GDP.

The policy rate is the culprit here. In the US, the policy rate was 2.5%, and after the pandemic the rate was reduced to 0.25%. With this policy rate, the US needs to pay $2.5 billion per year on a borrowing of $1,000 billion, while for the same amount of debt Pakistan would need to pay $70 billion, i.e. the cost of borrowing in Pakistan is 28 multiples of the cost in the US.

According to the SBP report, the government expenditures grew by 5% during the first half of FY21. This was due to the markup spending. The non-markup spending, including development, defence, pensions and running of the civil government, declined during the period compared to last year. The defence spending shrank by 8.1% and the development expenditures by 3.4% during the period. But all these reductions were offset by the huge increase in markup payments which made the overall spending grow by 5%. The markup payments during the same period grew by 15%, offsetting all the gains of reduced spending.

It should be a matter of concern that markup payments have grown rapidly and no attempt has been made to contain them. In the name of fiscal consolidation, the short-term treasury bills were replaced with longer-term Pakistan Investment Bonds (PIBs). Most of this conversion took place at a time when the policy rate was very high. About Rs8,000 billion of short-term debt was replaced with longer term debt during March-June 2019, the time when the policy rate was 12.25%. This conversion into longer term debt ensured that the markup will not decline in the future even if the policy rate goes down. Therefore, despite the fall of policy rate to 7% after the pandemic, markup payments are not going down.

Another problem is the repayment of debt borrowed from the SBP. This repayment was made by borrowing from commercial banks. If the government owes a debt borrowed from the SBP, as the custodian of the SBP, the government takes the entire markup paid on the debt. Therefore, the debt borrowed from the SBP is practically an interest-free loan. Replacing it with the debt borrowed from commercial banks will divert the markup payment from the government treasury to the coffers of commercial banks.

The objective of high policy rate and returning money to the SBP was to keep a check on inflation, but the objective could not be achieved. Inflation during the first half of FY 21 has been 7.3%, a level higher than the inherited inflation. Despite recognising inflation to be a supply side issue, the SBP did not reduce policy rate to allow growth and a fall in inflation.

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