Recent Changes in Monetary Policy in Pakistan

{text:bookmark} {text:toc-mark-start} PAKISTAN ECONOMIC POLICY {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} DATED: *15TH* DECEMBER 2009 {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Submitted To: {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Sir Ashraf Janjua {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Submitted By: {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Nimra Anjum {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Rakana Payam {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} {text:bookmark} {text:toc-mark-start} *Sheema H*asanat {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} ACKNOWLEDGEMENT {text:toc-mark-end} We would like to give our special thanks to our Pakistan Economic Policy teacher, Mr. Ashraf Janjua for giving us this opportunity to work and have an insight of the our country’s economy, also to let us interpret our learning in a real situation. We thank him for the assistance through out this project. Table of Contents MONETARY POLICY Monetary policy is the regulation of volume of money supply, by the central bank in order to achieve relative price stability. If the economy is heating up then the Central bank can increase the bank rate or the reserve requirement. Whereas when there is recession, then the bank rate is reduced. Instruments for the Regulation of Money Supply Open market operations. Cash Reserve requirement Statutory Liquidity Ratio Credit Ceiling Open market operations: It is the buying and selling of government securities. If the M.S is high then the securities are sold so that people buy it and money goes to the SBP and if the M.S is low then you buy securities in this way Money supply increases. Cash Reserve Requirement: It is a requirement in which all the commercial bank have to keep a percentage of cash with the SBP. Currently, it is around 7%. Statutory Liquidity Ratio: It is a requirement in which each bank has to maintain a certain reserve requirement to strengthen their liquidity position. Credit Ceiling: It is the fixation of the upper limit; quotas are assigned to different banks. Components of Money {text:bookmark} {text:toc-mark-start} Mo is the resource money and comprises of: {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Currency in circulation {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Bank’s Reserve with the SBP {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Other deposits with the SBP {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Cash in the tills of the Bank {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} M1= Currency in circulation + Demand deposits with scheduled banks + other deposits with SBP. {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} M2=M1 + time deposits with the scheduled banks. Technically, M2 is called Monetary Assets & M1 is called Money Supply. {text:toc-mark-end} How is Money Created? {text:bookmark} {text:toc-mark-start} There are three sources of creating money: {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Net Credit creation by the central Bank (SBP): Credit extended during a period minus recoveries. {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} 1 and 2 are called net Bank credit. Credit is always on the Asset side of Banks. When this credit is used by issuing cheques end up with bank (either the same bank/or any other bank). These cheques are deposits, and are on the liability side of the banks. These deposits/liabilities become money/monetary Assets, and are equal to the credit created by the Banking System. {text:toc-mark-end} How Much Money can be Created? {text:bookmark} {text:toc-mark-start} The share of currency in circulation in Mo and, {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Level of cash in tills and commercial banks reserves with SBP as a % of Mo. {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} The higher the value of either of these amounts with respect to M2, the lower the Money Multiplier. {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} 1/c + r (1-c) {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} C= the ratio b/w CIC + other deposits with SBP and M2 {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} R= Cash assets of Scheduled banks: Cash in tills of commercial banks + reserves with SBP. {text:toc-mark-end} DOES MONETARY POLICY PLAY EFFECTIVE ROLE IN CONTROLLING INFLATION IN PAKISTAN? Introduction {text:bookmark} {text:toc-mark-start} Inflation is politically costly for the government (Haque and {text:toc-mark-end} Salient Features of the Monetary Policy {draw:frame} {draw:frame} {draw:frame} Instruments of Monetary Policy {text:bookmark} {text:toc-mark-start} Cash Reserve Requirement {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} {draw:frame} {text:toc-mark-end} {text:bookmark} {text:toc-mark-start} Discount Rate {text:toc-mark-end} {draw:frame} INFLATION TREND IN PAKISTAN (2004-2009) According to the State Bank of Pakistan, the core inflation in the year (2005) was 8.8 per cent which has almost doubled since the last year (2004) in which the inflation rate was 3.8 per cent. During this year the non-governmental borrowing increased by 30 per cent. The two main reasons for high inflation during this period were because of excessive government borrowings and the price of wheat. According to the State Bank of Pakistan, government estimated that the inflation rate in the next year would range between 7.7 and 8.3 per cent.
During the year (2006) there was a decrease in the total inflation of the country (general and food) from 9.3 to 7.9 per cent and 12.5 per cent to 6.9 per cent respectively. The government took several major steps to bring the inflation down during this year as well by tightening the monetary policy and augmenting the supply of essential commodities through liberalization of import regime. As a result the general inflation declined from 9.3 per cent (2004-05) to 7.9 per cent (2005-06) & the non-governmental borrowing in the year 2006 became 23 per cent. During 2007 the core inflation reduced from 7.5 per cent to 5.9 per cent, due to tight monetary policy. According to the SBP the food inflation increased from 6.9 per cent (2006) to 10.3 per cent (2007) because of supply side constraints in which the prices of some key food staples (including wheat, rice, vegetable, ghee etc,) were increased. Where as comparatively the non-food prices grew at a slower pace since last year and the general Inflation (CPI) declined from 7.9 per cent to 7.8 per cent. The inflationary trend in the food prices during the year (2008) increased to 17.6 per cent as compared to the last year in which the food inflation was 10.3 per cent, affecting people living standards of low and fixed income groups. The non-food inflation had the same increasing trend as in the year (2007), which was 6.0 per cent and during the year (2008) was 7.9 per cent. Although the core inflation was reduced to 5.9 per cent but during this year it went back to 8.4 per cent because of the global increase in some commodity, higher utility tariff and by local supply and demand driven prices.
Inflation during (2008) indicates that the prices of a few commodities (18) essential food items registered sharp increase particularly during the second half of the fiscal year (2008). Other significant contributors to (2008) upward inflationary trend included house rent, which is the index that measures the cost of construction in Pakistan, racing to 11.3 per cent by April (2008). The current fiscal year commenced with ease in headlines compared to the same month of previous fiscal year. The consumer price inflation annually was 11.2 per cent during July (2009) as against 24.3 per cent in July (2008) and 13.1 per cent in the previous month. A major increase in the core inflation was witnessed in July (2009) of 17.6 per cent as compared to July (2008) 8.4 per cent. The food inflation increased by 6.1 per cent during this fiscal year. The main reason for this high inflation was due to low export growth relative to import, high oil prices and inadequate foreign capital inflow. Conclusively, one can say that inflation adversely affects the overall economic growth, the financial sector development and exploit the vulnerable poor segments of the population. Inflation also decreases the real income and induces uncertainty. Considering such undesirable impacts of inflation on the economy, there's a consensus among the world leading central banks that the price stability is going to be the prime objective of monetary policy and the central banks are committed to lower the inflation in the economy. Hence the State bank of Pakistan should adopt inflation as their main focus of monetary policy, by targeting inflation explicitly or implicitly as and when required. EFFECTIVENESS OF MONETARY POLICY STATEMENT IN PAKISTAN Economic policies aim to increase the welfare of the general public and monetary policy supports this broad objective by focusing its efforts to promote price stability. Embedded in this objective is the belief that persistent inflation would compromise the long term economic prospects of the country.

The objective of monetary policy in Pakistan, as laid down in the SBP Act of 1956, is to achieve the targets of inflation and growth set annually by the government. In pursuit of this mandate, SBP formulates the country's monetary policy that is consistent with these announced targets. In my remarks today, I plan to provide perspective on: First, why central banks focus on price stability? Second, how the monetary policy transmission mechanisms work? Third, what are the principal features of Pakistan's monetary policy framework? Fourth, selected thoughts on effectiveness of Pakistan's monetary policy framework Finally, what measures are needed to improve the effectiveness of the monetary policy framework in Pakistan? These questions have been a subject of much debate lately, as monetary tightening - an inevitable policy response for regaining macroeconomic stability - has aroused anxiety but better public understanding of this question will help them to appreciate central bank's monetary policy stance. Why Focus on Price Stability? Monetary Policy Transmission Mechanism The monetary transmission mechanism refers to a process through which monetary policy decisions affect the level of economic activity in the economy and the inflation rate. Understanding the transmission mechanism of monetary policy is crucial for appropriate design and efficient conduct of monetary policy.

As monetary policy actions affect policy variables with a considerable lag and with high degree of variability and uncertainty, it is important to predict the possible impact and extent of monetary policy actions on the real variables. Thus, by its very nature, monetary policy tends to be forward-looking. It is also important to know which transmission channels are more effective in terms of transmitting changes in monetary policy actions to ultimate policy goals.

Since various financial sector developments particularly regarding introduction of new financial products, technological changes, institutional strengthening, and expectations about future policy, etc can potentially change economic effects of the monetary policy measures, there is a need to regularly update, empirically test and reinterpret monetary policy transmission channels. The impact of monetary policy is perceived to transmit in to the real economic activity through five channels.

• The first channel and most widely studied and understood channel of monetary policy transmission relies on the link between changes in the short-term nominal interest rate (induced by changes in the policy rate) and the long-term real interest rate that ultimately affect components of aggregate demand such as consumption and investment in an economy. As such, it is the changes in the long-term real interest rates that have its impact on aggregate consumption, business investment and other components of aggregate demand.

• The second channel, known as the credit channel, involves changes in monetary policy that not only affects the ability of firms to borrow money (by affecting their net worth) but also affects the ability of banks to lend money. The strength of this channel depends on the degree to which the central bank has allowed banks to extend loans and the dependence of borrowers on bank loans. These factors are clearly influenced by the structure of the financial system and its regulation.

• The third channel of monetary policy transmission focuses on asset prices (other than the interest rate) such as the market value of securities (bonds and equities) and prices of real estate. A policy-induced change in the nominal interest rate affects the price of bonds and stocks that may change the market value of firms relative to the replacement cost of capital, affecting investment. Moreover, a change in the prices of securities entails a change in wealth which can affect the consumption of households.

• Fourth, a policy-induced change in the domestic interest rate also affects the exchange rate that in turn affects the foreign financial flows, net exports and thus aggregate demand.

The strength of the exchange rate channel depends on the responsiveness of the exchange rate to monetary shocks, the degree of openness of the economy, sensitivity of foreign private inflows and net exports to exchange rate variations, and the net worth of firms and thus their borrowing capacity if they have taken exposure to foreign currency. Moreover, exchange rate changes lead to changes in the domestic price of imported consumption goods and imported production inputs affecting inflation directly.

• Since expectations influence the inflation dynamics, there is a fifth channel that is based on the economic agents' expectations of the future prospects of the economy and likely stance of the monetary policy.

According to this 'expectations channel', most economic variables are determined in a forward-looking manner and are affected by the expected monetary policy actions. Thus, a consistent, credible, and transparent monetary policy can potentially affect the likely path of the economy by simply affecting expectations. Monetary Policy Framework in Pakistan Considering the economic and financial market structure in Pakistan, SBP has for sometime pursued a monetary targeting regime with broad money supply (M2) as a nominal anchor to achieve the objective of controlling inflation without any prejudice to growth.

The process of monetary policy formulation usually begins at the start of the fiscal year when SBP sets a target of M2 growth in line with government's targets of inflation and growth (usually in the month of May) and an estimation of money demand in the economy. The basic idea is to keep the money supply close to its estimated demand level, as both a significant excess and a shortfall may lead to considerable deviations in actual outcomes of inflation and real GDP growth from their respective targets.

Underlying this framework are two strong assumptions: first, there is a strong and reliable relationship between the goal variable (inflation or real GDP) and M2; and second, the SBP can control growth in M2. While containing the M2 growth close to its target level is the key consideration in the current monetary framework, the composition of the money supply does matter and at times requires policy actions even if these actions lead to a deviation in monetary growth from its target level.

To understand this point, it is necessary to know the major components of money supply and their relative importance. Net foreign Assets (NFA) and Net Domestic Assets (NDA) of the banking system are the two major components of money supply.

The NFA is the excess of foreign exchange inflows over outflows to the banking system, or in other terms it is a reflection of underlying trends in the country's external Balance of Payment (BoP) position. It is estimated by the projected values of all major external transactions such trade, workers' remittances; debt servicing, foreign investment, and debt flows etc.

The NDA of the banking system, which primarily consists of credit to the government and the private sector, reflects changes in the fiscal and the real sectors of the economy, If is estimated as a residual of M2 and the NFA. Further break-up of NDA is estimated on the basis of projected credit needs of the government and the private sector.

NOW coming to the importance of these components of the money supply, depletion in NFA is generally considered as an unhealthy development. Sharp NFA depletion reflects worsening BOP position and a pressure on exchange rate. In such a case, a higher NDA growth, though helps in expanding M2 to reach ifs target level, may further deteriorate external accounts, sharper depreciation of local currency, and higher depletion of country's foreign exchange reserves.

Although since FY07, only the indicative M2 growth target is being announced, SBP also takes into consideration the causative factors for monetary expansion while pursing this target. Considering the changes in monetary aggregates and other economic variables, the changes in monetary policy are signaled through adjustments in the policy discount rate (3-day repo rate).

Further, the changes in the policy rate are complemented by appropriate liquidity management mainly through Open Market Operations (OMOs) and if required changes in the Cash Reserve Requirement (CRR) and Statutory Liquid Reserve requirement (SLR) are also made."

Significance of various channels that transmit the monetary policy shocks in Pakistan to the real economy has been analyzed by few economists. Ahmad et al. (2005) found that credit channel is the most 'important conduit for transmitting monetary policy actions to the real economic activity. Evidence confirms transmission through the active asset price channel and exchange rate channel.

According to this study, monetary policy shocks impact real output after a lag of 7 to 11 months. Tasneem and Waheed (2006), on the other hand, investigated whether different sectors of the economy respond differently to monetary shocks.

The presence of sector wise differences in the monetary transmission mechanism has profound implications for macroeconomic management as the central bank then has to weigh the varying consequences of its actions on different sectors. Investigating the transmission of changes in interest rate to seven sub sectors of the economy, the authors found evidence supporting sector-specific variation in the real effects of monetary policy.

They found that the interest rate shock on manufacturing, wholesale and retail trade, and finance and insurance sectors transmit after a lag of 6 to 12 months. On the other hand, monetary policy shocks have negligible impact on agriculture, mining and quarrying, construction and ownership of dwelling sectors.

Generally, historical evidence does reflect that Pakistan has been a high inflation and high interest economy given its inherent structural weaknesses. The role and effectiveness of monetary policy appears more visible in the 2000s when financial sector reforms started bearing fruits in terms of a more market based money and foreign exchange markets.

Entering the 21sf century, the loose monetary policy stance in the face of low inflation, low growth and low twin deficits, along with structural measures to open up the economy and alleviate some first round constraints, triggered the economy on a long-term growth trajectory of above 7 percent.

Monetary policy stance was however altered as the inflationary pressures started to build up in 2005. At the end of the fiscal year, the economy, which had been showing sustained steady growth since FY01, registered a historically high level of growth (9 percent), average inflation rose sharply (9.3 percent) and the external current account balance turned into deficit (-1.4 percent of GDP)

Coinciding with these developments, the fiscal module started to show signs of stress as the fiscal balance was converted into a deficit and the stock of external debt and liabilities, which had been declining since FY00 after the Paris Club rescheduling, began increasing. These indicators largely capture the high and growing aggregate demand in the economy on account of sustained increase in peoples' income.

With the emerging domestic and global price pressures, SBP tightened its monetary policy after a prolonged gap of a few years. The efforts to rein-in inflation, however, proved less effective due to a rebound in international commodity prices and a rise in domestic food prices later on.

The rise in the international commodity prices, particularly oil, exacerbated the fight against inflation. The international oil prices (Arabian Light) rose from US$27.1 at end 2004 to US$50.9 at end 2006, whereas international food prices rose by 24, 24 and 21 percent during 2004, 2005 and 2006 respectively.

Realizing the complications of monetary management and adverse global and domestic economic developments, the implementation of SBP monetary policy during FY06 varied significantly from the preceding fiscal years. In addition to the rise in the policy rate, the central bank focused on the short-end of the yield curve, draining excess liquidity from the interbank money market and pushing up short-tenor rates.

Consequently, not only did the overnight rates remain close to the discount rate through most of the year, the volatility in these rates also declined. These tight monetary conditions along with the Government's administrative measures to control food inflation helped in scaling down average inflation from 9.3 percent in FY05 to 7.9 percent in FY06, within the 8.0 percent annual target.

This was certainly an encouraging development, particularly as if was achieved without affecting economic growth as the real GDP growth remained strong at 6.6 percent in FY06. Further Strengthening of Tight Monetary Policy For FY07, the government set an inflation target of 6.5 percent. To achieve this, a further moderation in aggregate demand during FY07 was required as the core inflation witnessed a relatively smaller decline in FY06, indicating that demand-side inflationary pressures were strong.

In this perspective, SBP further tightened its monetary policy in July 2006 raising the CRR and SLR for the scheduled banks; and its policy rate by 50 basis points (bps) to 9.5 percent. Moreover, proactive liquidity management helped in transmitting the monetary tightening signals to key interest rates in the economy.

For instance, the Karachi Inter Bank Offer Rate (KIBOR) of 6 months tenor increased from 9.6 percent in June 2006 to 10.02 percent at end-June 2007 and the banks' weighted average lending and deposits rates (on outstanding amount) increased by 0.93 percentage points and 1.1 percentage points, respectively, during FY07.

In retrospect, it appears evident that monetary tightening in FY07 did not put any adverse impact on economic growth, as not only was the real GDP growth target of 7.0 percent for FY07 was met, the growth was quite broad based. At the same time, the impact of the monetary tightening was most evident in the continued deceleration in core inflation during FY07.

One measure of core inflation, the non-food non-energy CPI, continued its downtrend from YoY high of 7.8 percent in October 2005, to 6.3 percent at end-FY06, and to 5.1 percent by the end of FY07. However, much of the gains from the tight monetary policy on overall CPI inflation were offset by the unexpected rise in food inflation.

On the downside, however, broad money supply (M2) grew by 19.3 percent during FY07, exceeding the annual target by 5.8 percentage points. Slippages in money supply growth largely stemmed from an expansion in NFA due to the higher than expected foreign exchange inflows. Equally stressful was the impact of Government borrowings from the central bank during the course of the year. The pressure from the fiscal account was due to mismatch in its external budgetary inflows and expenditures.

With the privatization inflows and the receipts from a sovereign debt offering at end-FY07, the Government managed to end the year with retirement of central bank borrowings, on the margin. By end-FYO7, SBP holdings of government papers were still around Rs 452 billion, despite a net retirement of Rs 56.0 billion during the year.

Another major aberration in FY07 emanated from the high level of SBP refinancing extended, for both working capital and long-term investment, to exporters. Aside from monetary management complexities, these schemes have been distorting the incentive structure in the economy. FY08 and Beginning of FY09: More Challenging

FY08 was an exceptionally difficult year. The domestic macroeconomic and political vulnerabilities coupled with a very challenging global environment caused slippages in macroeconomic targets by a wide margin.

After a relatively long period of macroeconomic stability and prosperity, the global economy faced multifarious challenges: (i) hit by the sub prime mortgage crisis in U.S in 2007, the international financial markets had been in turmoil, the impact of which was felt across markets and continents; (ii) rising global commodity prices, with crude oil and food staples prices skyrocketing; and (iii) a gradual slide in the U.S dollar against major currencies.

Combination of these events induced a degree of recessionary tendencies and inflationary pressures across developed and developing countries. Policy-makers were gripped with the dual challenge of slowdown in growth and unprecedented rising inflationary pressures. Central bankers faced a demanding task of weighing the trade-off between growth and price stability.

With the exception of few developed countries, most central banks showed a strong bias towards addressing the risk of inflation and responded with tightening of monetary policies. On the domestic front, the external current account deficit and fiscal deficit widened considerably to unsustainable level (8.4 and 7.4 percent of GDP).

The subsidy payments worth Rs 407 billion by Government, which account for almost half of the fiscal deficit, shielded domestic consumers from high international POL and commodity prices and distorted the natural demand adjustment mechanism. While the government passed on price increase to consumers, the rising international oil and other importable prices continued to take a toll on the economy.

Rising demand has cost the country dearly in terms of foreign exchange spent on importing large volumes of these commodities. Rising fiscal deficit and lower than required financing flows resulted in exceptional recourse of the Government to the highly inflationary central bank borrowing for financing deficit. At the same time the surge in imports persisted.

As a result, inflation accelerated and its expectations strengthened due to pass through of international oil prices to the domestic market, increases in the electricity tariff and the general sales tax, and rising exchange rate depreciation. These developments resulted in a further rise in headline as well as core inflation (20 percent weighted trimmed measure) to 25 percent and 21.7 percent respectively in October 2008.

Considering the size of macroeconomic imbalances and the emerging inflationary pressures, SBP remained committed to achieve price stability over the medium term and thus had to launch steeper monetary tightening to tame the demand pressures and restore macroeconomic stability in FY09. SBP thus increased the policy rate from 13.5 to 15%. What Needs to be Done to Improve the Effectiveness of Monetary Policy? Apart from taking policy measures to address the emerging challenges, SBP also introduced structural changes in the process of monetary policy formulation and conduct to make the monetary policy formulation and implementation more transparent, efficient, and effective. Specifically, during the last couple of years, SBP focused on

• Institutionalizing the process of policy formulation and conduct

• Stepping up movement towards a more market based credit allocation mechanism

• Developing its analytical and operational capacity

• Improving its capabilities to assess future developments to act proactively and

• Improving upon the communication of policy stance to the general public.

However, the following areas need attention and are keys or effective monetary management.

1. Effectiveness of monetary and fiscal co-ordination would be helpful. Section 9A and 9B of the SBP Act (amended in 1994) articulates the institutional mechanism for economic policy making and co-ordination and defines the ground rules for both the process and the policy making. However, the track record of the Monetary and Fiscal Policies Co-ordination Board (MFPCB), established in February 1994 that requires quarterly meetings of the SBP and the government, has been less than satisfactory. Furthermore, the sequencing of economy-wide projections is done in isolation of the budget and monetary policy making process, and the budget making process has not respected the monetary compulsions. With rising spending and stagnating revenues, the budget assumes at the start of the year certain recourse to the central bank rather than treat it as mere ways and means advances.

2. For effective analysis of developments and policy making, timely and quality information is extremely important. However, due to weaknesses in the data collection and reporting mechanism of the various agencies of the country, information is not available with desired frequency and timeliness. Also there are concerns over the quality of data. Unlike many developed and developing countries, data on quarterly GDP, employment and wages, etc is not available in case of Pakistan.

Moreover, the data on key macroeconomic variables (such as government expenditure and revenue, output of large-scale manufacturing, crop estimates, etc) is usually available with substantial lags. This constrains an in-depth analysis of the current economic situation and evolving trends, and hinders the ability of the SBP to develop a forward-looking policy stance.

3. Unlike many countries, both developed and developing, there is no prescribed limit on government borrowing from SBP defined in the SBP Act or the Fiscal Responsibility and Debt Limitation (FRDL) Act 2005. Besides being highly inflationary, government borrowing from SBP also complicates liquidity management.

Borrowing from the central bank injects liquidity in the system through increased currency in circulation and deposits of the government with the banks. In both cases, the impact of tight monetary stance is diluted as this automatic creation of money increases money supply without any prior notice. Moreover, access to potentially unlimited borrowings from the SBP provides little incentives to the government to put the fiscal accounts in order.

Therefore, the foremost task to improve the effectiveness of monetary policy is to prohibit the practice of government borrowings from the SBP. In this regard, appropriate provisions are required to cease or limit government recourse to central bank financing through amendments in the SBP Act and the FRDL Act 2005.

4. Another issue is to make a clear distinction between exchange rate management and monetary management. Currently, there is a general perception that the State Bank is bound to keep the exchange rate at some predefined level and any movement away from this level is then considered as an inefficiency of the SBP.

There is a need to understand that for an open economy, it is impossible to pursue an independent monetary and exchange rate policy as well as allowing capital to move freely across the border. Since the SBP endeavors to achieve price stability through achieving monetary targets by changes in the policy rate, it is not possible to maintain exchange rates at some level with free capital mobility.

This can only be achieved by putting complete restrictions on capital movements, which is not possible. SBP's responsibility is to ensure an environment where foreign exchange flows are driven by economic fundamental and are not misguided by rent seeking speculation. 5. Finally, based on experience particularly gained during the last two months is to differentiate between liquidity management and monetary policy stance.

Recently, when the banking system experienced extraordinary stress due to shallow liquidity in the system, rumor mongering heightened the general public anxiety over few banks' sustainability. Consequently, the SBP had to intervene in the market by injecting ample liquidity through various measures. In some quarters, these changes were deemed as a change in the bank's tight monetary policy stance.

However, this was not the case and the bank had to clearly and repeatedly communicate that the existing stance is being continued. Later on, the bank further tightened its monetary policy. It must be understood that quite often, liquidity management can drive the market interest rates away from the direction desired under the monetary policy stance. However, this has to be temporary and 'the interest rates are bound to move in the policy stance direction.

To resolve this issue, the SBP is studying various options, including the introduction of a "Standing Deposit Facility" to keep the interbank rate within a corridor.

In conclusion, it is imperative that above steps be taken urgently. Over the period, however, this needs to be complemented with much deeper structural reforms to synchronize and reform the medium term planning for the budget and monetary policy formulation process Several studies and technical assistance have provided extensive guidance in this area, but the lack of capacities and short term compulsions have often withheld such reforms.

What is important is to recognize that a medium term development strategy, independently worked out, would help minimize one agency interest which has often been a source of co-ordination difficulties. It would also help the budget making process more rule based than the incrementally driven process to satisfy conflicting demands. THE RECENT DEVELOPMENTS IN MONETARY POLICY (2007-2009) The SBP has kept its tight monetary policy stance in the period July 01, 2008-April 20, 2009. The policy rate was adjusted upward in November 2008 to shave-off some aggregate demand from the economy and kept constant in January 2009. However, noticing visible signs of demand compression enabled the SBP to reduce 100 basis points on April 20, 2009. During July 01, 2008-April 18, 2009, money supply (M2) expanded by 1.6 percent against the target of expansion of 8.0 percent for the year and last year expansion of 8.1 percent in the comparable period of last year. The reserve money witnessed contraction of 2.2 percent in this period as against expansion of 10.3 percent in the comparable period of last year. Net domestic assets (NDA) have increased by Rs.307 billion as compared to increase of Rs.627.5billion in last year. However, it is showing an increase of 7.6 percent in stock during this period, whereas, last year the growth in stock was 20.4 percent in the comparable period. Net foreign assets (NFA) have recorded a contraction of Rs.263.9 billion against the contraction of Rs.356.4 billion in the comparable of last year [See Table-6]. {draw:frame} Government borrowing for budgetary support has recorded an increase of Rs.240.5 billion as compared to Rs.336.0 billion in the comparable period of the last year. The government has over performed against freezing the net borrowing from SBP at Rs.257 billion in 2008-09 and the SBP financing has shown a net increase of Rs.103.3 billion and financing from scheduled banks witnessed a net increase of Rs.137.2 billion during July 01, 2008-April 18, 2009. Credit to private sector witnessed a net increase of Rs.55.4 billion during July 01, 2008-April 18, 2009 as compared to Rs.359.7 billion in the comparable period of last year. The stocks still went up by 9.1 percent. SBP undertook aggressive monetary tightening during the period, further increasing the policy rate by 300 bps in two rounds. On a cumulative basis, this means a 550 bps increase during the last 18 months up to March 2009. However, the policy rate was decreased by 100 bps on April 20, 2009. These policy measures were in response to carryover of macroeconomic stresses of the preceding year and increase in real aggregate demand. Monetary tightening has worked in the right direction. Weighted average lending rate have witnessed slight decline from 15.5 percent in October 2008 to 14.8 percent in February 2009. Weighted average deposit rate on the other hand has increased from 6.2 percent in October 2008 to 7.0 percent in February 2009 which implies narrowing of the spread amidst intensive deposit mobilization efforts on the part of the banks. The weighted average yields on 6 months T-bill has declined by almost 250 basis points to 11.5 percent in March 2009 as against 14 percent in November and December 2008 [See Fig-2]. {draw:frame} Recent Discount Rate in Pakistan (2007-2009) During 2007-08, the SBP continued with tight monetary policy stance, thrice raising the discount rate and increased the Cash Reserve requirement (CRR) and Statutory Liquidity Requirement (SLR). In the light of continued inflationary buildup and increasing pressures in the foreign exchange market, the SBP announced a package of monetary measures on May 21, 2008 that included;(i) an increase of 150 bps in discount rate to 12 percent; (ii) an increase of 100 bps in CRR and SLR to 9 percent and 19 percent, respectively for banking institutions (iii) introduction of a margin requirement for the opening of letter of credit for imports (excluding food and oil) of 35percent, and (iv) establishment of a floor of 5percent on the rate of return on profit and loss sharing and saving accounts. The year 2008-09 is characterized by a reduction in CRR by 2 percent in two equal phases to help the liquidity issues of the banking system. Later on, the SBP announced a 200 bps hike in discount rate to 15 per cent on November 12, 2008 in response to persistent hike in core inflation and current account deficit in a last ditch effort to demand compression. Following a slight reversal in the mounting inflationary and demand pressures, the SBP announced a downward adjustment of policy rate by 100 bps on April 20, 2009. SBP’s tight monetary policy and rationalization of fiscal subsidies and expenditure controls are the key factors that contributed a reasonable progress towards macroeconomic stability. The private consumption grew by 5.2 percent in real term during 2008-09 which implies that notwithstanding substantial reduction in the fiscal and current account deficits, demand pressures are still confronting monetary management. {draw:frame}