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Text of speech of the Governor of State Bank of Pakistan at the
Golden Jubilee of Pakistan Institute of Development Economics on
March 11, 2008. Resilience of Pakistan's economy in the face of
unforeseen global and multiple domestic shocks has been a subject of
debate - proponents of outgoing Government arguing that it has
strengthened, while opponents criticise the state of the economy.
In these circumstances, I propose to provide a neutral, unbiased and
economic reasoning for why and where we stand today? I encourage
Pakistan Institute of Development Economics (PIDE) to further
investigate and provide a professional economic perspective on the
economy with the objective of feeding properly into policy advice.
In providing my perspectives, I propose to highlight the emerging
challenges posed by the weak global economic scenario, its
consequent impact on the domestic economy which was already under
strain, and then discuss the policy options and solutions,
especially the structural changes that are required to put Pakistan
on the road to sustainable economic recovery.
Pakistan entered the 21st century after displaying an average
economic performance in the 1990s on numerous fronts. In deference
to the historical pattern of growth path and associated business
cycles, the economy gained momentum.
From 2000 onwards: foreign exchange reserves grew, the debt-to-GDP
ratio fell, and inflation, in particular core inflation,
decelerated. Dynamism of financial sector, benefiting from the
change of ownership and management and strong regulation and
supervision, helped revive real economy and exploited untapped
economic potential. Financial sector assets rose to $180 billion
(125% of total GDP) as banks' were capitalised and the stock market
remained buoyant. Corporate and banking sector profitability
attracted cumulatively foreign direct investment of $11.9 billion,
remittances at $22.4, and net portfolio flows were $5.0 billion.
Since late 2004 domestic vulnerabilities re-emerged and mounted as
the fiscal and external current account deficits rose above 4% of
GDP and induced inflationary pressures. Risks to macroeconomic
stability just after few years of robust growth and stability are
not surprising. A quick review of Pakistan's economic history
reveals that episodes of strong economic growth in the 1960s and
then in 1980s were both followed by the slowdown in growth and
weaknesses in macroeconomic indicators.
Why is Pakistan vulnerable to these cyclical downturns? Why cannot
the country have sustainable economic performance? The oscillating
growth performance over the years is largely because of inherent
domestic structural rigidities which have yet to be effectively
tackled to ensure macroeconomic stability and the desired growth
path. Proper diagnosis and effective resolution of issues and
implementation of broad ranging structural reforms is critical to
skirt such bouts of slowdown in growth and instability.
Aside from the broader development debates, what is unusual
currently is that Pakistan's economy is simultaneously faced with
twin shocks, global and domestic. The global shocks are represented
by international financial market turmoil and the unprecedented
increase in global commodity prices, while rising fiscal and
external current account imbalances characterise the domestic
shocks. In the backdrop of (relative) slowdown in foreign exchange
inflows in FY2008, these shocks have resulted in pressure on the
exchange rate and foreign exchange reserves, heavy government
borrowings from the central bank, and a rise in domestic inflation.
Combined, both international and domestic events have complicated
short term economic management disrupting monetary management which
had succeeded in bringing the core inflation down to 5.2% by May
2007- below the peak levels of 8.3% in October 2005 and brought to
surface more starkly the vulnerabilities economy faces. Like most
economic phenomenon, these international shocks and domestic
deficits are interrelated and entail stringent tradeoffs when it
comes to devising and implementing a well-co-ordinated, timely, and
enduring policy response.
Unless immediately addressed, the present economic vulnerabilities
emerging in Pakistan's economy risks reversal of the high growth
trajectory and even disruption of the gains achieved. Below, I
attempt to give the basic reasons for the (re)emergence of these
shocks and deficits, highlight the complexities, and suggest some
sustainable solutions.
Worldwide central bankers, economic policy makers and businesses are
overwhelmed as global economy slides in tailspin. Financial market
turmoil caused by subprime debacle has sparked numerous debates
regarding the origins of this event, effects of its aftermath, both
in terms of contagion and policy responses across the globe.
Risks of spread of contagion associated with US and UK's credit
crisis and liquidity crunch have compounded as the financial and
economic losses magnify and thwart global financial stability and
economic growth prospects. Combined with record-high international
commodity prices (in particular oil and food prices) global
inflationary risks have intensified. Emerging markets like Pakistan,
which were thus far insulated mainly due to low exposure to the
subprime paper, are likely to be impacted by the second round
effects of the financial market turmoil which are now visible by way
of sluggish world economic growth as US downturn is setting in.
To mitigate these risks, US has launched a unprecedented package
involving: easing liquidity through special funding windows, cutting
policy rate, in five rounds, to 225 bps and providing US $200
billion fiscal package. This package, while warranted, is fairly
controversial because of the associated moral hazard and
inflationary consequences of rate cuts and easing of liquidity.
Since the appropriate size of the stimulus cannot be calibrated with
any precision, the aggressive stimulus by way of a monetary
accommodation is likely to compound the global inflationary
pressures which were already rising in the wake of (i) supply
constraints magnified due to worldwide shortages of strategic
products (such as wheat) and oil substitution efforts that diverted
use of corn as a bio-fuel and (ii) growing demand pressures with
rising world income.
Fuelling the international commodity prices has also been the fall
in US dollar which has driven investors to chase gold and oil
markets. In a globally integrated world the costs of re-anchoring
inflation expectations are likely to be punitive. No wonder, other
central banks, with the exception of few such as Federal Reserve and
Bank of England, have either further tightened their monetary policy
or kept on hold to existing levels of tightening.
Developing understanding of the origins of the financial crisis and
adequacy of its policy responses is critical. Analysts have largely
identified collapsing US sub-prime mortgage market as the key cause
for financial market turmoil.
However, the sub-prime mortgage debacle appears more of a symptom
rather than a cause of this evolving credit crisis. Underlying
causative factors is the sustained decline in inflation and
inflation volatility and the associated notable decline in nominal
and real interest rates in most developed and developing economies.
This resulted in complacency and central banks' adopted
accommodative monetary policy for longer period that induced
excessive liquidity. Combined with regulatory and supervisory gaps
in oversight of off-balance sheet and non-bank transactions, this
provided opportunities for over-leveraging without appropriate risk
management frameworks.
Arguably, these developments increased appetite for and under
pricing of risk (although the pricing of risk was (and is) becoming
increasing difficult in the face of fast-paced financial
innovations), elevated asset prices, increased capital flows across
borders in search of better yields (reflecting global macro
imbalances), 'carry trade' and currency misalignments.
Although, monetary conditions had begun to tighten, the sub-prime
mortgage crisis caused liquidity squeeze that resulted in loss of
confidence and panic among investors and lenders (and now central
banks) as they could not offload the complex risky assets and
structured financial products.
Since banks turned to rescue and bought off chunks of these papers,
with low mark-to market valuations these resulted in losses to a
number of financial institutions and write offs required capital
injections. This fortunately was possible given the growth in
sovereign funds which are waiting for acquisition and other deals.
Could it be possible that by accommodating the oil and food prices
and (attempting) to revive the economy, US is setting the stage for
another round of easy monetary policy and liquidity situation. In my
opinion, the key issue for central banks is to differentiate between
need for short-term liquidity to rescue troubled financial entities
and need for adoption of a credible monetary policy stance which
aims to calibrate liquidity management in a way that it does not
aggravate inflationary risks which in turn would trigger further
complication and protract the global economic recovery.
While lowering interest rates, central banks have to weigh
inflationary risks against the risk of recession and financial
instability. In bailing financial entities, the central banks have
to be concerned with "moral hazard" associated with such policy
response as it often encourages more risky endeavours by salvaging
institutions whose sole purpose of existence is risk taking and
profit making.
Not only is Pakistan facing different sets of complex challenges,
but the emerging global economic scenario itself underscores that
country does not mimic the policy response of advanced economies.
Advanced countries that are selectively lowering interest rates are
those that have enjoyed low inflation for sometime but are now
facing steeper risks of downturn.
As such, there trade off for growth supportive policies relative to
inflation is understandable as risks associated with US slowdown
would threaten global economic outlook and financial
vulnerabilities.
Pakistan on the other hand has relatively stable financial system,
but mounting aggregate demand pressures are now visible in rising
inflation and rising inflationary expectations. Tightening of
monetary stance and flexible exchange rate management are the two
key central bank policy responses. These however will have more
distinct impact if the Government reverts to fiscal prudence and
efforts to this count are visible through recent reduction in oil
and other subsidies.
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