Why Pakistan's inflation is worse than China's

Government borrowing, not monetary expansion, drives price rises

ISLAMABAD:

Every time the State Bank of Pakistan (SBP) lets money supply grow drastically by issuing bonds or by injecting rupees on account of remittances, we expect inflation in a while. But when the People's Bank of China does something similar, no one in Beijing worries about inflation. For perspective, in 2026, Pakistan's headline inflation sits around 11%, while China's has hovered around 1%, despite both central banks expanding M2 supply by a similar magnitude.

Milton Friedman used to say that inflation is "everywhere and always a monetary phenomenon," but why does monetary expansion produce a cost-of-living crisis in one country and not in the other?

The honest answer is that it depends on where the money goes, not how much of it there is. Inflation results from a rise in the quantity of money relative to output. Printing money is inflationary, specifically when it makes demand grow faster than the economy's capacity to produce goods and services. If new money instead expands supply – new factories, new export capacity, new infrastructure – then it does not create the imbalance that shows up as rising prices.

China's state-directed banking system routes new credit through businesses, state-owned enterprises, and local governments that end up in manufacturing, infrastructure, and property construction, and not household consumption. Under 'window guidance,' Chinese banks don't primarily compete on interest rates as regulators tell them which sectors to lend to. The result is that when China expands the money supply, it mostly builds capacity. Supply keeps pace with or outpaces demand, and prices stay flat or fall. Moreover, a high savings rate means that the velocity of money stays low, further suppressing inflationary pressures.

In contrast, when Pakistan's monetary base expands, the dominant channel is not credit to productive private investments but rather financing the government's own deficit. A large and growing share of bank balance sheets is parked in government T-bills and Pakistan Investment Bonds, instruments that fund debt servicing, subsidies, and public sector salaries rather than factories or export capacity. No asset creation takes place, and all the capital goes to the big, fat government machinery. This is demand entering the economy with no matching expansion in what the economy can produce – precisely the condition that predicts inflation.

In other words, the "demand pressure" driving Pakistan's inflation is concentrated in government wage bills that are financed by the same deficit spending that is responsible for expanding the money supply, and in the consumption of upper-income and import-facing households. With a poor savings rate, the ordinary private-sector workers are paying the price of inflation without receiving the income growth that would normally accompany it.

Private credit is crowded out by government borrowing, so private investment and hiring stay weak, private wages stay flat, and when the SBP tightens policy to fight the resulting inflation, the burden lands disproportionately on the private sector. Average nominal wages in the private sector have remained stagnant, leaving real purchasing power lower, not higher. But formal government-sector wages, boosted by repeated civil service and military pay revisions funded directly from the federal budget, have risen way faster than the roughly 72% of the non-agricultural workforce sitting in the informal sector, where wages are uncounted and unprotected.

All parties that are somehow linked with government, including employees, contractors, bankers, etc, form the elite that enjoys considerable competitive advantage over the rest of the masses. When demand from this elite group rises, output cannot rise with it. The pressure has nowhere to go but into prices, especially in the housing market. New demand that leaks into imports shows up quickly as rupee weakness, which itself becomes a second round of imported inflation.

It's worth pausing on the SBP's recent InvestPak initiative here because it makes it easier and more attractive to lend to the government, now from a wider retail base and further away from the private productive investments that Pakistan needs.

So, what can we borrow from the China model in such a scenario? Pakistan should not and cannot replicate a closed capital account or a banking system run on administrative window guidance; the institutional and political preconditions simply aren't there, and the costs of getting it wrong would be severe. But the underlying principle, that the destination of credit matters more than its volume, is a page worth taking seriously.

Firstly, fiscal consolidation reduces the government's need to crowd out the banking system. If T-bills and PIBs offer banks a risk-free double-digit return with zero underwriting effort, there is no interest-rate signal strong enough to pull credit toward private lending. The deficit is the root cause; instruments that make government debt easier to buy only intensify the pull. For this to stop happening, parliament needs to play an active role by debating budget requirements and by pulling the plug on the 'supplementary budget' loophole. These supplementary budgets empower the executive machinery to have infinite budget overruns – that are rubberstamped by parliament ex-post facto every year.

We also need differentiated prudential treatment for private, productive lending, like lower capital or reserve requirements for loans to export-oriented manufacturing or SMEs relative to government paper, and for narrowing the risk-adjusted return gap that currently favours lending to the state. State-owned enterprises (SOEs) and private companies formed by these SOEs should be excluded. A fixed portion of new bank lending should be directed towards capacity that expands what Pakistan can produce and export rather than what it can borrow.

PSDP needs to be revamped and should be designed around public-private partnership (PPP) frameworks with mandatory vetting of private sector proposals. It should be insulated from political subsidies, and there should be a hard cap on project backlogs. No project on completion should lead to an increase in the size of existing ministries, and after completion, operations should be run exclusively by the private sector.

None of these changes the money supply arithmetic overnight. But the fight against Pakistan's inflation is not primarily a State Bank interest-rate exercise, and it isn't solved by making it easier to lend to the government, however well-intentioned the reform is. It remains a question of whether new money, however much of it there is, ends up building the economy's capacity to produce, instead of simply financing its ability to consume what it has not yet earned.

THE WRITER IS A CAMBRIDGE GRADUATE AND WORKS AS A STRATEGY CONSULTANT