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The rising prices dilemma.

Pakistan's economy, under the policies of the former Prime Minister and former and present Governors of the State Bank of Pakistan (SBP), witnessed a historical era of high growth. The real GDP growth remained above or around 7 percent during 2004-07. The average growth of the last four financial years was 7.5 percent. This tremendous growth in the economy was due to the growth oriented economic policies in Pakistan, supported by suitable international economic conditions.

The extent of success of such policies depends on the level of institutional capacity and some other economic, social and political factors. In the absence of these factors or if not managed intelligently and proactively the same policies can also bring fragility in the economy. One of the indications of this fragility is high and sustained rise in prices.

An increase in the general price level (measured through a statistical index) of goods and services over a period of time, say one year, is called inflation. Popular methods of presenting inflation are 'year on year basis' and 'average of year on year growth for the financial year'. In Pakistan the second method is usually used to indicate headline inflation. The first method is also often used and is very useful for depicting the exact growth in prices over any 12 months.

Inflation up to a particular level, slightly different for every economy, is considered necessary to encourage investment and production and allow growth in wages. For Pakistan, some studies estimate that this level is around 3 to 6 percent. Another level of inflation, again slightly different for every economy, is the one beyond which it starts delivering negative effects to the economy. National currency starts losing its value and saving and investment is discouraged. This eventually hurts the economic growth. Casual empiricism suggests that for Pakistan, this threshold rate of increase of prices is about 11 percent. On the basis of 12-month changes in prices, Pakistan's inflation rate touched this threshold in April 2005

When the previous government assumed office, inflation was only 3.8 percent. It went up to 5.4 percent in November 2000 and then dropped to the lowest, 1.4 percent, reverse trend and Started climbing, reaching' 11.1 percent in April 2005. State Bank took serious notice of the situation and started introducing some tight management of the monetary policy. But probably it was slimly late. Inflation did decline but did not go below 6.2 percent. Touching 6.2 percent in April 2006 it ascended back to around 9 percent in August and December 2006.

In the monetary policy July-Dec 2006 some more monetary measures were taken, which included raise in the discount rate by 50 basis points to 9.5 percent, Cash Reserve Requirement (CRR) for demand liabilities from 5 to 7 percent, and statutory liquidity requirement for the scheduled banks from 15 to 18 percent. To encourage growth in long-term liabilities CRR on such liabilities was reduced from 5 to 3 percent. The impact of these measures was, however, felt with one year lag. Inflation came down to 6.4 percent in July 2007.

The declining trend, however, could not sustain and in September 2007 inflation jumped back to 8.4 percent and then the very next month it touched 9.3 percent, the highest of the last two and a half years. And let me say that it has all the strength to reach the 11 percent level in a matter of just few weeks.

The impact of policy measures introduced in monetary policy of July-Dec 2007 might be felt with one year lag but in the presence of conditions such as growing current account deficit, weakening Pak Rupee, expected larger fiscal deficit and hence expected sizeable growth in government borrowing, increasing trend of hoarding of food commodities such as wheat, recent surge in cement prices and international prices of wheat and palm oil etc, rising national debt, and rising foreign inflows, it is very hard to believe that the monetary policy alone can manage inflation.

The situation is exacerbated by the expectations of large increase in fuel prices-not raised since May 01, 2006. Estimates show a 10 to 15 percent rise in the first step. The start of election process has made it difficult for the government to shift the rise to the consumers but now the options are vanishing.

Before giving any suggestions let us first understand the mechanism.

A research paper appearing in the 'Pakistan Development Review (PDR)'-a leading research journal, explains that several economic factors can be responsible for the surge in inflation. It is important to understand that the growth oriented policies are supposed to put upward pressure on prices, particularly in the take-off stage. Policy makers know that the growth would be accompanied by higher inflation. So, they have to be proactive in deciding the acceptable level of inflation and the time of applying necessary checks on prices.

It is also well understood by the policy makers that the relationship between inflation and economic growth depends on the state of the economy. An economy can experience high growth without an increase in inflation if its productive capacity (or potential output) is also expanding rapidly, so that supply is more than keeping pace with demand. It can also experience rapid growth without inflationary pressures if output is below potential and the economy has a lot of catching up to do. In such a situation, because there are unemployed resources, a rapid expansion of demand employs unutilized factors of production, thereby generating income and spending and further employment, and so on, which leads to higher growth, put catches up with the potential output, there remains no spare capacity and the economy is working on full employment level, any further gain in growth comes at the cost of rising inflation. If demand continues to grow at this stage, and the productive capacity does not expand, there is a serious threat of rapid inflation in the long run without any additional growth in the output. Such an economy needs to be cooled down through such measures as a tightening of monetary policy. This is because, in the long run, an increase in demand at a rate greater than the rate of increase in productive capacity would only lead to higher inflation, without any additional economic growth-or worse, a negative effect on growth.

The demand side pressures are caused by expansionary monetary policy, expansionary fiscal policy, major increase in foreign remittances and investments etc. In Pakistan demand pressures built up because of a combination of many factors such as the increase in foreign inflows and remittances as an outcome of 9/11 incident, liberal demand management policies, emergence of various consumer financing schemes at extremely low rates etc. As a result domestic demand outpaced the domestic production, creating a positive output gap, which put upward pressure on prices. Private consumption grew rapidly en FY04 and FY06, depicting signs of demand side pressures on price level.

The growing gap between domestic demand and domestic production was filled by a sharp increase in net imports, resulting from liberalization of trade. Growth in imports more than surpassed the growth in exports and the large trade deficit invited imported inflation.

Rising trade deficit can be a cause of expectations of high inflation in future. The expectations' effect can be severe because there is a danger that the current high rate of inflation can get locked into expectations of inflation, which then can convert into an inflationary cycle which would go on re-emerging despite the tightening of monetary policy. This occurs because people expect higher salaries to compensate for expected increase in prices, speculation in asset prices increases, credit meant for manufacturing sector diverts to real estate and stock markets, and hoarders, profit seekers and rentiers become active in expectation of high price in future.

Expansionary fiscal and monetary policies in combination with liberalization policies result in the growth of fiscal deficit and current account deficit, which precisely has happened over the last few years. Such a policy combination widens the investment-saving gap, which has to be financed externally. Saving to investment ratio in Pakistan has reached one of the lowest in Asia.

Financing of the deficits also gets more and more difficult. Financing fiscal deficit through money creation adds to inflationary pressures. On the other hand borrowing from commercial banks in general and from central bank in particular can also have serious consequences for the general price level.

Financing current account can work in the short run but in the long run it is not feasible because foreign investments are very volatile. A country's dependence on foreign investment in the presence of uncertain political situation can bring its international rating down.

Exchange rate, if depreciating, in this scenario can also put upward pressure on price level. Increase in prices of goods, such as petrol, raw material etc makes our imports costlier and hence increase the cost of production. But when dollar is losing its value against other major currencies and rupee on the other side is getting weaker against dollar, the situation intensifies.

On fiscal side too much dependence on indirect taxes to fill the gap created by liberalization of imports, can raise the prices of consumer goods drawing away the gains of import liberalization from them. This creates inflationary pressure. On the other hand, direct taxes reduce the take-home income and thus have anti-inflationary impact.

A substantial increase in support price of wheat, according to one study, is estimated to have an inflationary effect on consumer prices, particularly food prices. This effect is due to the fact that wheat and wheat-related products account for 5.1 percent of the CPI basket.

Inflation can also be a result of shocks to the supply of major agricultural commodities such as wheat, cotton, rice, palm oil etc and major fuel products such as crude oil, gasoline etc. Rising oil prices affect the prices of most of the commodities of consumer basket. Such supply-side shocks are very volatile and can cause large fluctuations in Consumer Price Index (CPI) in general and food and oil price index in particular. The effects of such shocks on overall inflation at times can be so excessive that these cannot be countered through demand management, including monetary policy.

1990s was the period when mainstream liberalization policies got their momentum in Pakistan. Frequent changes in the government and inconsistency of the policies, nuclear explosion and 2 other dramatic political and economic factors put upward pressure on prices. Average inflation rate during the decade was 9.6 percent. Studies mention that the increase in procurement prices of wheat, government borrowing, private sector borrowing, exchange rate depreciation and adaptive expectations were the main factors behind the surge in inflation rate during 1990s.

During 2001-04 inflation was very low. Interestingly, support price of wheat was not raised during 2001-03. CPI shot up again in 2004-05 when inflation reached 9.3 percent It dropped slightly to 8 percent in 2005-06. According to the PDR study, Inflation expectations alone explained 45.73 percent of the inflation in 2005-06.

Non-government sector borrowing was the second most important factor. During 2004 and 2005 the growth in non-government borrowing was 23 percent in 2006. This growth is reflected in the 35 percent contribution of NGSB in the inflation of 2005-06. Another important factor was import prices, which explained 26.7 percent of the inflation in 2005-06.

Two other important factors were government borrowing and support/procurement price of wheat, which contributed, 17.6 percent and 11.8 percent respectively.

With this analysis and understanding of the mechanism let us propose some policy measures.

The cotractionary stance of monetary policy is quite appropriate. However, any further tightening canuiscourage investment and growth. Some expansion of credit to the private sector is necessary to stimulate the economy. Nevertheless the credit should strictly be geared towards increasing supply capacity. In other words it should be channelled more conceitedly toward physical investment to prevent it from leading to too much speculative activity in the real estate and stock markets.

Some measures are required to ensure that the commercial banks offer better returns on long-term deposits, at least an increase of 3 percentage points. It must also be ensured that the measures announced in the monetary policy of July-Dec 2007 must be maintained in the Jan-June 2008 policy and the government borrowing from the central and commercial banks should be reduced. Financing through long-term papers can make commercial banks to increase their returns.

Having said this, it is maintained that the monetary policy alone, at this stage, cannot control inflation. Some excellent management of fiscal and administrative measures is necessary to support monetary policy. Broad based direct taxes are a must. Direct to indirect taxes ratio must increase. Social safety nets, including coupons for free medical treatment, discounted prices of essential commodities shall be introduced. Heavy investments in bio-fuels need to be encouraged to reduce country's reliance on imported fuel products. Opportunities of investments in agricultural projects must be explored and supported, in compliance with the WTO agreements.

These measures cannot only help in reducing prices down but can also gain popularity for the government, which is much needed for the upcoming elections.
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Author:A-leem Khan, Abdul
Publication:Economic Review
Geographic Code:9PAKI
Date:Nov 1, 2007
Previous Article:Reflections on global economic and financial developments.
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