Recently, Finance Minister Ishaq Dar was all fire and brimstone when the rupee fell against the dollar by about 3pc. Sure enough, a day later, the acting governor of the central bank was consigned to his temporal purgatory. There were hints of a conspiracy that led to the fall in rupee, though State Bank of Pakistan’s (SBP) announcement should have put that to rest.
Regardless of what drove the rupee correction, one thing is clear. The finance minister was grossly misguided in his reaction. This episode was another reminder of what is wrong with our institutions.
Contrary to what the law and good practice say, the minister visibly showed that the central bank was not independent. He reinforced this by chairing a meeting next day of the heads of all commercial banks to discuss the earlier day’s change in rupee value. The acting governor was not invited.
Usually, the governor of an independent central bank would preside over such consultations. The finance minister also announced appointment of a new governor of the State Bank of Pakistan, a retired civil servant who, until a few days before, was his finance secretary. Such brazen lack of respect for institutions may be good for the ego, but it is poison for the economy. These actions also defy economic logic. The state of the economy is a tribute to our contempt for institutions as well as for economic rationale.
Commenting on the incident, a former PPP finance minister said that “SBP is now part of the Ministry of Finance” and re-tweeted a condolences message about its imminent demise.
Why should the Central Bank be independent?
Few institutions affect the lives of citizens as much as the central bank. It makes monetary policy that controls money supply. It sets benchmarks, which decide the cost of borrowing for businesses and consumers. It issues paper money and clears cheques drawn on banks. It also regulates all commercial banks. Central bank policies affect the job market as well as success of firms. More than any other arm of the state, it influences economic growth and stability.
Leading experts universally hold faith in the autonomy of the central bank. The mandate of most central banks, including SBP, is to make economies grow and to keep prices low. As we see below, there is an inherent tradeoff between the two. This calls upon technocrats of the bank to keep in place, at all times, a delicate balance.
Aggregate demand in an economy moves growth. One way to increase demand is for government to spend more, especially on investment. Usually, that is hard to do as revenue streams are given. Another way to change total demand is through the central bank’s monetary policy. Its key instrument is interest rates. A lower interest rate increases demand for money. This leads to higher spending on working and fixed capital and on consumption. Increased demand stimulates growth, but also prices. High interest rates dampen demand for money. That lowers prices as well as growth.
What makes central bank autonomy critical is that monetary policy takes a long time to affect the economy. Monetary policy, hence, must have a long-term perspective. This is especially necessary because of the competing demands of the two goals of growth and low prices. The time lag makes it vital that central banks are insulated from short term political goals. For best economic outcome, growth must be consistent with the economy’s productive capacity. On the other hand, short term goals of elected
One of the bank’s key task is to manage money supply, including through printing of notes. Two centuries ago David Ricardo opined that the executive cannot be trusted with the task of printing paper money. There is too much temptation to abuse this power to help finance the budget. Since then, in every economy, the central bank has managed money supply. This also requires that the central banks place limits on government borrowing.
Central bank independence does not mean complete freedom. The SBP Act enunciates its broad goals. Political leadership in parliament sets the goals for the economy, which SBP must follow. SBP’s stipulated goals are monetary stability and growth of the economy.
Has the independence worked?
We can see the benefits of central bank independence worldwide. Overall, there are improved monetary policy practices. In most economies, inflation has been in control. We no longer see economies in hyperinflation with money rapidly losing value. “Empirical studies support the view that independent central banks deliver better inflation outcomes than less independent banks, without compromising growth.”
There is, however, the devastating example of the 2008 fiscal crisis that soon became a world economic crisis. What happened is hard to say as the growing asset bubble was for everyone to see. There were clear warning signs as early as 2003, when economists pointed out massive macro imbalances because of heavy foreign borrowings by the USA. Did the federal reserve delay increased in interest rate to ensure low cost funding for the large US deficit caused mostly by its two wars? We would never know. Central bankers, especially those who assume star status in industrial economies, do not accept mistakes easily. However, the entire world suffered the joint effect of US government and federal Reserve’s egregious neglect.
This incident reinforces the perils of central banks working too closely with government and, even more, reiterates the need for autonomy in practice as well as in letter. Very quickly, the US federal reserve took measures to right the grave wrong.
This is a lesson that should not be lost on our State Bank. The law gives the State Bank autonomy, but it has not fully used it. There is wide gap between formal and actual autonomy. The result is for all to see.
What is the SBP’s mandate? Are there issues with delivery of mandate?
As said before, SBP Act entrusts the Bank to conduct monetary policy in line with parliament’s growth and inflation target. A Monetary and Fiscal Policies Co-ordination Board aligns fiscal, monetary, and exchange rate policies. It does these in support of the mandated goals of stability and growth. The law gives SBP enough autonomy to fulfil its responsibility to meet:
- “the primary functions including issue of notes, regulation and supervision of the financial system, bankers’ bank, lender of the last resort, banker to Government, and conduct of monetary policy, and
- the secondary functions including the agency functions like management of public debt, management of foreign exchange, etc., and other functions like advising the government on policy matters and maintaining close relationships with international financial institutions.
- Non-traditional or promotional functions, performed by the State Bank include development of financial framework, institutionalization of savings and investment, provision of training facilities to bankers, and provision of credit to priority sectors. ”
For several years, growth stayed below 4%. Inflation has been under control, but more because of the high rupee value and low oil prices than fiscal prudence. In recent years, fiscal deficit has exceeded GOP’s estimate. To finance these, GOP has borrowed way beyond the budget, often at the cost of insufficient private sector credit.
These gaps in SBP’s performance are not minor. It’s most serious effect lies in letting a profligate government avoid reforms. Rather than allow government easy access to credit, with long term deleterious effect on the economy, the SBP must enforce limit on borrowing. This would move GoP to practice prudence in public finance. GoP would then either increase revenue or limit spending, and hopefully make the latter more effective.
What is the SBP’s role in fixing exchange rate?
The law gives SBP the power to manage foreign currency matters. Section 9A 1(b) says that SBP must “oversee foreign exchange reserve management” and send to parliament quarterly reports on the economy including on the balance of payments (9A 2). The document ‘State Bank functions’ says that “One of the major responsibilities of the State Bank is the maintenance of external value of the currency.”
SBP also has fallen short on its goal to ensure “competitiveness of our exports.” GoP’s fetish for a high value of the Rupee may have caused exports to decline. Pakistan’s REER has appreciated by 22% since 2013. While Pakistan has lost competitiveness, India, Bangladesh, and Sri Lanka have gained .
What next for the new Governor?
Given the circumstances, the new governor’s appointment has become controversial. This is not what SBP needed. Forty opposition members have moved a resolution in the Senate for his removal . Other experts have called him not deserving of the job. It is now for the new governor to meet expectation.
He must establish his bonafide and assert his authority. He must lead SBP to play its designated role in building a strong economy. Equally the board must step up to support the governor. SBP must:
- Independently make realistic economic analyses of macro-economic trends and forecasts.
- Insist on regular meetings of the Monetary and Fiscal Policies Coordination Board. The law calls for quarterly meetings.
- The Board sets targets for growth, inflation, and balance of payments, as well as foreign reserves. SBP must verify the extent and reasons for variation of GoP estimates from its analyses.
- Based on above, SBP must meet its Section 9C obligation to set limits for GoP borrowings and estimate private credit needs. SBP’s estimates must input into government budget.
- With government, it must watch and review progress on these targets, and persuade GoP to not go beyond the borrowing limit. In the past, SBP has denied such access to government.
- It must assume absolute control over monetary policy without formal or informal GoP influence. It must base interest rate movement entirely on its own analysis.
- SBP must meet its obligation to regulate banks and not compromise the trust that the law places in it.
- The SBP Board must play a more active and effective role and strengthen the hands of the governor.
- The president must appoint the SBP governor as well as all board members. News about the governor’s appointment must not come from the Finance Ministry. Ideally, parliament must have a say in the appointment. As a transition matter, a Board of economic minister may recommend the candidate for the President’s approval.
- SBP must play its role in exchange rate and Balance of Payment management. The risks and the downside to the economy of not doing so are very high.
Princeton Professor Alan Blinder quashes the notion that central banks must work “amidst secrecy, blue smoke and mumbo jumbo. Central Banks work through the financial markets …. and markets (do not) function better when they are less informed.” Former Fed Chair Bernanke says, “Transparency about monetary policy not only helps make central bank more accountable, it also increases effectiveness of policy.”
Institute for Policy Reforms is an independent and non-partisan think tank established under Section 42 of the Companies Ordinance. IPR places premium on practical solutions. Its mission is to work for stability and prosperity of Pakistan and for global peace and security. IPR operations are supported by guarantees from the corporate sector.