A critical analysis of the SBP’s second quarterly report

The State Bank of Pakistan (SBP) has recently released its second quarterly report on the State of the Economy in Pakistan. While most analysts use the report to discuss the performance of the government, there is a lot in the report to judge the performance of the SBP and the Debt Coordination Office of the Ministry of Finance. After the spread of Covid-19, the entire world adopted the policy of Quantitative Easing to support the recovery from economic recession. At the same time, the nexus of the Debt Coordination Office and the State Bank were busy in the so-called fiscal consolidation which is exactly the opposite of Quantitative Easing. Here is what the report says about the monetary and fiscal policies adopted by Pakistan and the comparison of these policies with global practices.

Chapter 4 of the report is about fiscal policy and public debt. The chapter starts by stating proudly that, “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. The word surplus sounds terrific, but in reality it is not. The primary budget had also recorded a surplus during the last year, yet the federal budget had an overall deficit equivalent to 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.

A deficit in the time of a pandemic is not something peculiar. Many countries reported record high deficits during 2020. For example, the United Kingdom (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. Developing economies like Brazil and South Africa also recorded huge increases in the fiscal deficit. The extraordinarily large deficits in these countries occurred due to Covid related spending. You will find approximately equal or higher level of Covid relief packages in these countries. For example, the UK and Canada spent 18% and 19% of their GDPs respectively on Covid relief. The Covid relief package announced by the Government of Pakistan was about 2.6% of GDP, compared to 8.1% of the deficit. Actually, this announcement had serious biases, and already existing social spending programmes like BISP and pending government liabilities were also counted in the Covid relief packages. The surplus primary budget achieved during the pandemic indicates a reduction in real government spending. The entire deficit occurred because of the markup payments. A very strange reality is evident from these facts; the government is ready to afford over 8% of the deficit to pay the markup, but it is not ready to consume a half percent deficit for the social spending which was direly needed during the pandemic.

Unfortunately, the meager funds allocated for the Covid relief package could not be utilised. According to some media reports, the Covid related spending other than the Ehsas programme during the 10 months of the current fiscal year has been only 27% of the funds allocated for the purpose. This austerity in the time of extreme need has led to the primary surplus; but the primary surplus sank in the ocean of markup payments to post a huge overall deficit.

The markup payments have been so high because of 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 (US) 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. This contrast exists because of the choice of policy rate. In the US, the policy rate was 2.5%, and after the pandemic the policy rate was reduced to 0.25%. With this policy rate the US needs to pay 2.5 billion per year on a borrowing of 1000 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.

The SBP quarterly report also confesses that the Federal expenditures grew by 5% during the first half of FY21, and a major contribution to this growth came from mark-up spending. The non-mark-up spending including development, defence, pensions and running of 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. Having a high inflation, the fall in defence spending in real terms must be much greater. This indicates that the government is ready to compromise on defence, on the real incomes of poor pensioners and on the essential spending of the government; however, no austerity applies to the markup payment. Markup payments are allowed to grow without any bound and no attempt has been made to contain them.

In fact, the nexus of the Debt Coordination Office and the SBP has created the circumstances leading to faster growth in the markup payments. 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 the time when the policy rate was very high. About 8000 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 insured 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 reducing because the markup has been decided in advance.

Till now, the government is continuously converting the remaining short term debt into longer term PIBs carrying a much higher price than the policy rate. Today, the coupon rate offered on 20Y and 30Y PIBs is 11%, which shall be paid continuously till the maturity of the bond happens after 20 to 30 years. In this way, the government has decided the cost of borrowing not only for its own tenure, but also for the future governments till the maturity of the bond.

Another development during the Pakistan Tehreek-e-Insaf (PTI) regime is the repayment of debt borrowed from the SBP. This repayment was done 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, practically, the debt borrowed from the SBP is 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. When the government took charge, the SBP debt was about 5 trillion, and had risen to 7.3 trillion in March 2019. The government then adopted the policy to replace this debt with commercial bank borrowing; hence today the debt has been replaced completely. Today, government borrowing from the SBP is zero. Therefore, a huge amount of markup will now land in the coffers of commercial banks. As discussed earlier, during the pandemic, all major economies borrowed extensively from their central bank. Pakistan proceeded in exactly the opposite direction and repaid central banks borrowing with commercial bank borrowing. The quarterly report informs that during the first quarter of FY21, the government repaid 586 billion to the SBP.

So far, the government has repaid 7.3 trillion to the SBP. Hence the question arises: what will the SBP do with this money?  The SBP will lend this money to the commercial banks at KIBOR and the commercial banks will lend back to the government through PIBs carrying 8%-11% coupon rate. Therefore, the banks are insured to earn profit on money not actually owned by them.

By borrowing so heavily from the commercial banks, the government has emerged as the largest competitor of the private businesses. As per the SBP report, the government’s budgetary borrowing from commercial banks has been 1023 billion during the first half of FY 21; about half of this amount was borrowed to repay the SBP debt. On the other hand, the bank lending to the entire private sector has been 343 billion, of which only 219 billion were lent to the business sector. The banks are able to earn a guaranteed profit by investing in government securities, and they have absolutely no interest in lending to the businesses. While financing the private sector, banks prefer to lend in the form of personal and consumer loans where the bank margin is too high and the banks are able to earn more than double of what they earn from government securities.

The SBP report notes that the inflation today is a supply side issue driven mainly by food prices. Standard economic theory says that if inflation is supply side, the high interest rate will add to the inflation. Therefore, accommodating monetary policy is needed not only to allow growth, but also to reduce inflation. The SBP reports also mentions that the accommodating policy is needed today, and the SBP considers the current monetary policy to be accommodative, comparing it to the level of policy rate in November 2019, which is actually higher than the rate inherited by the incumbent. After the onset of the pandemic, most of the countries reduced their policy rates drastically and as mentioned above, the policy rate in Pakistan today is 28 multiples of the policy rate in the US, 70 multiples of the UK rate, and 14 multiples of the rate in Thailand.

The objective of high policy rate and returning money to the SBP is to keep a check on inflation, but on this front, the failure of this policy is also evident from the SBP report. The report informs inflation during the first half of FY 21 has been 7.3%, a level higher than the inherited inflation. The SBP report notes that the inflation is driven mainly by food inflation, a supply side source of 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. The urban inflation in food prices average to about 14%, of which the inflation in wheat prices has been 38%.

The most unfortunate fact is that the largest volume of markup payments, which grew by 15% during FY 21, happened in the era of economic recession. The SBP report at several points notes that high policy rate and debt profiling of debt tenure are the reasons behind this fast growth in markup payments. The costs of the policy rate hike, replacement of the SBP loans and the debt profiling was to reduce inflation and there is no evidence in the entire report which shows the success of the policies in controlling inflation. Project Inflation Control, which cost several trillions and consumed 42% of the federal budget, is still unevaluated. There is no evaluation/audit of the effectiveness of the monetary policy, neither in this report nor anywhere else on the SBP website.