Dr. Omer Javed |
Two economic policy statements have recently surfaced, from SBP in the shape of Monetary Policy Statement (MPS) and Ministry of Finance (MoF) introducing Finance Bill (FB) in the parliament for approval.
While economic agents- especially domestic and foreign investors- need clarity of public policy, yet both MPS and FB are sending opposite signals; since the former is pursuing a tight monetary policy stance for some time, whereby in the recent MPS- effective February 1, 2019- the policy rate has been increased by 25 basis points to 10.25 percent, while the FB has adopted a loose fiscal policy by lowering taxes and duties, and allowing more space to non-filers.
So while the MPS wishes to dent aggregate demand in the economy, since it wishes to reduce rising core inflation, will in turn negatively impact economic growth, steps announced in FB are intended to attract greater spending and investment to overall boost the rate of growth. Hence, the rising conflict of policy.
Indirect taxes add to inflation, which should not be curtailed by damaging investment by raising the interest rate and reducing capacity to demand loanable funds and consumption.
At the same time, will rise in interest rate actually be able to make a significant reducing impact on inflation; and at what cost given the economy needs to produce jobs at the back of investment and growth, since after all this is what the PTI governments indicated in its manifesto, and this is what is needed in a country where one-third of the population is already below the poverty line, and where the income inequality is very much skewed in favor of a tiny rich elite.
In developing countries, research has indicated that inflation is at least equally a fiscal phenomenon, and not just primarily a monetary one. There are many reasons for this. Firstly, markets suffer from high transaction costs- search and information costs- along with heavy indirect taxes that add to the retail price level. The interest rate hike will not do anything to reduce this, for which is needed institutional reform of markets, in addition to improvements in governance and incentive structures.
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In Pakistan, the economy is dominantly an agrarian commodity markets, and such transaction costs, including costs arising from speculative practices, the inordinate share of the middle man, means that the price of products contains a lot more than just a small profit margin and the cost of production. That needs to be corrected through government intervention.
Another problem is that policymakers are heavily biased towards orthodox economics, and does not learn from new or heterodox economics since otherwise there is the concept of hybrid markets, where there is some sort of hierarchy to check the inefficiencies and failures of markets as indicated above. At the same time, the government needs to move towards progressive direct income and wealth taxation policy regime, so that prices of domestic production and imported goods does not carry a heavy burden of indirect taxes in the shape of large sales tax, and high customs duties.
On the contrary, the interest rate hike will lead to higher interest payments on domestic debt, countering the very basis of reducing the fiscal deficit through such hike, since it will most likely rise in the wake of these higher interest payments.
As a corollary look at the global price of crude oil and a lot higher price of petroleum products that government receives from domestic consumers, by adding to the price petroleum levy, sales tax, and other margins. Why should government tax in such a lopsided and regressive way?; Which is also to point out a much-trumpeted argument of last government that they have increased tax collection so much, while most of it is a consequence of increases in indirect taxes; and if at all should be held accountable for. Indirect taxes add to inflation, which should not be curtailed by damaging investment by raising the interest rate and reducing capacity to demand loanable funds and consumption.
Thirdly, by most estimates, almost half of the economy works on a cash-based system, where money exchanges hand and is raised for investment without the intermediary of the formal financial system- bank and non-bank financial institutions. Hence, raising the interest rate will not matter to the consumption of those operating in the black economy, who will continue to be a source of demand-pull inflation, which will be all the more since there will be lesser investment and manufacturing at the back of tight monetary policy.
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If at all, the interest rate needs to decrease to make monetary policy analogous to the fiscal policy in the latter’s stance of encouraging investment, growth, and employment opportunities. Low, stable and predictable levels of inflation should be pursued for macroeconomic stability, but in the case of a developing country like Pakistan, it is more of fiscal phenomena and needs to be dealt accordingly.
A developed country policy stance- where the economy has a big financial sector, transaction costs are low, the black economy is virtually non-existent, and where markets reach better price signals without much government intervention- of using interest rate to pull down inflation, has historically only reduced inflation, if at all much, for a short time since the fundamentals that really cause most of inflation are in the fiscal domain.
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On the contrary, the interest rate hike will lead to higher interest payments on domestic debt, countering the very basis of reducing the fiscal deficit through such hike, since it will most likely rise in the wake of these higher interest payments. Moreover, it will increase the cost of borrowing on loans needed for seeing through the PM Housing initiative.
Also, it will crowd out a domestic investor, along with foreign direct investment at the back of higher user cost of capital. Is this what the government want: not much impact on inflation and reduced investment and growth prospects? I don’t think so. Therefore, time to put the house in order of economic policy is indeed overdue.
Dr. Omer Javed holds Ph.D. in Economics from the University of Barcelona, Spain. A former economist at International Monetary Fund, he is the author of Springer published book (2016), ‘The economic impact of International Monetary Fund programmes: institutional quality, macroeconomic stabilization, and economic growth’. He tweets at @omerjaved7. The views expressed in this article are author’s own and do not necessarily reflect the editorial policy of Global Village Space.