Undermining the SBP’s independence

The finance minister, announcing the monetary policy, raises serious questions related to SBP’s current operations

Recently, the finance minister of Pakistan announced the monetary policy for the following two months, and declared a 100-basis point reduction in the discount rate, even before the State Bank of Pakistan (SBP) had made its official statement regarding this. Not only does this statement hamper the already shaky credibility of the SBP, but also raises questions about its institutional transparency and independence, its true economic mandate and the objectives and targets of the monetary policy.

It is interesting to note that monetary policy autonomy is mandated to the SBP by three amendment ordinances, including the State Bank of Pakistan Act, 1956, Banking Companies Ordinance, 1962, and Banks Nationalisation Act, 1974. These ordinances granted full and exclusive authority to the SBP to regulate the banking sector, to conduct an independent monetary policy and to set limits on government borrowings from the SBP. Lack of credibility, transparency and the inability to bind government borrowing has eroded the SBP’s institutional credibility, affecting current economic activity and a failure to achieve any medium- or long-term macroeconomic objectives. The current finance ministry has undermined the SBP’s autonomy by undoing the independent monetary policy committee set up in 2010. It has also removed the limit on government borrowing introduced in that period.

The hallmark of an effective monetary policy in terms of achieving economic objectives as described above rests on transparency, i.e., what the central bank does; and credibility, which may be understood as how the central bank operates. The finance minister, announcing the monetary policy, places a question mark on both these pillars, and raises more serious questions related to the SBP’s current operations since monetary policy credibility affects inflation expectation, and establishing a history of living up to its word is prized by any central bank. Credibility is built the old-fashioned way, by building a track record for honesty and achieving legally-mandated objectives. Would firms and stakeholders believe an SBP whose credibility was doubtful? Uncertainty about future rates would drive firms away from investing in long-term projects. Future monetary policy actions would be distrusted by stakeholders if credibility was low, rendering monetary policy ineffective, causing losses in both foreign and local investment. Transparency is even less complicated.

If the SBP is mandated to achieve low inflation — legally or through its own institutional objectives — the issue of the minister knowing what the central bank is going to announce also raises questions about institutional transparency and independence. Monetary policy is increasingly characterised by trade-offs between achieving full employment or low inflation. In the case of a conflict between the two supposedly independent institutes, i.e., the finance ministry and the SBP, the ministry has chosen to ensure unrestrained financing for the budget deficit. This has undermined the central bank’s inflation-fighting objective, and consequently, affected its credibility.

Globally, there are various examples of effective monetary policy implementation. In the US, the Federal Reserve is mandated under the Federal Reserve Act of 1913 with the responsibility of setting the monetary policy. The US Treasury, which works as the finance ministry of the country, has no direct control over its open market committee, either in influencing the interest rate, or in other policy deliberations in normal circumstances. It took the Federal Reserve a few decades after the Great Inflation of the 1970s — especially during the Volcker period, where interest rates reached unprecedented highs of 17 to 19 per cent — to win back its lost credibility, and it has since switched to a more transparent monetary policy by announcing explicitly its monetary policy objectives in 2012. Closer to home, the appointment of Raghuram Rajan as chairman of the Reserve Bank of India in 2013 has signified the Indian government’s preference in stabilising inflation, signalling the demise of the old system of appointment of subservient central bankers, usually senior bureaucrats. At this crucial juncture, it would be prudent for our government to learn from our neighbour and allow the SBP to evolve into a de facto independent institution, rather than just a de jure independent institution. 

Published in The Express Tribune, February 5^th,  2015.

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