- Malaysia in the 1990s is instructive
In the recent statement on the staff-level agreement between Pakistan and the IMF on a three-year EFF (Extended Fund Facility) programme- for about US$6 billion, the following sentences raised concern: ‘The State Bank of Pakistan will focus on reducing inflation, which disproportionately affects the poor, and safeguarding financial stability. A market-determined exchange rate will help the functioning of the financial sector and contribute to a better resource allocation in the economy.’
Firstly, as is clear from long-term economic data in Pakistan, and also research since the 2007-2009 Global Financial Crisis, the lack of effectiveness of traditional monetary policy tools, like raising the policy rate, to control inflation has surfaced quite strongly. While in the developed world this led to the phenomena of ‘unconventional monetary policy’ and ‘quantitative easing’ to deal with ineffectiveness of loose monetary policy in inducing inflation, investment and growth, in the developing countries the lack of negative correlation between policy rate and inflation became quite evident over time.
Therefore, even when tight monetary policy was used for longer periods, the consequences on inflation were both limited and transitory. Rather, there has been a strong call to the use of fiscal policy, and better governance to deal with market failure, as some of the tools to share the needed burden- in addition to monetary policy- of policy response to curbing inflation.
Although, Pakistan may not fix the exchange rate given the huge current account deficit and low foreign exchange reserves, along with high external debt servicing requirement, yet it should adopting both a managed float, and capital controls
Yet, this response of research analysis over time has somehow continued to evade the thought process of both the government policy mindset and the IMF’s policy prescription. This is what worries people as they see the statement above, whereby once again the State Bank of Pakistan (SBP) has been mainly– rather virtually solely– tasked to deal with inflationary pressures.
Moreover, this policy prescription in the statement coming at the back of the country being the most aggressive user of tight monetary policy in Asia since over a 12-month period now, is disappointing. Certainly, there is a lot of scope for institutional reform of both real and financial markets, along with appropriate introduction of fiscal policy and governance-related reforms to deal with market imperfections. Perhaps, there could have been even a policy prescription to rationalise prices through a price commission and wage board.
What is missing from this programme, like previous ones, is the ability to shift from the neo-classical or neo-liberal ideological bias of placing over-emphasis on curtailing aggregate demand in dealing with macroeconomic imbalances. Rather, there should be a balanced policy stance, whereby focus is placed on both curtailing aggregate demand, and boosting aggregate supply. This is all the more needed for a low-growth, high-inflation situation like Pakistan, where also tight monetary policy has had little impact and a lot of growth and employment has been sacrificed over time.
Moreover, given a developing-country context of weak regulatory environment, the foreign exchange market being left alone in a floating exchange rate regime– as in the policy document– is a call for large currency value changes in a short time, at the back of a high volume of speculative activity.
This is bad, among other consequences, in terms of high inflation pass-through since the country is suffering from a high current account deficit, where also being a heavy oil-importing country, the commodity price shock travels to many commodities in the inflation basket of goods and services; especially the price of energy as a large proportion of energy supply is oil-based. Already lack of needed SBP intervention has led to a sharp slide of the Rupee– reaching historically unprecedented levels– since this government came to office some nine-plus months ago.
The way out requires both following a managed-float regime, and placing effective capital controls. This also needs to be seen in the light of the sharp rise globally in financial crises since the 1970s– when financial liberalisation and deregulation first started. Hence, while there were few such occurrences happening between 1940s and 1970, when there were effective capital controls and the banking sector was also strongly regulated, the number of banking and financial crises worldwide jumped to 124 during 1970-2007!
In developing countries, the first financial crisis happened in Malaysia, among other Southeast Asian countries during 1997-1999. Although Malaysia did not approach the IMF, it nonetheless initially did adopt some of the main IMF policy prescriptions- raising interest rates to control outflow of capital, floating the currency for free capital flows, lowering the definition of non-performing loans, which in the case of Malaysia was lowered to three-months (from an earlier six).
Rather than these policies managing the crisis, the initial currency and financial crisis turned into a full-blown financial crisis by 1998– aggregate domestic demand declined, primarily at the back of 55 per cent decline in private investment, and 10 per cent in consumption. At the same time, there was contraction in the real economy of 14 per cent; real GDP growth plummeted from 7.7 per cent in 1997 to negative 6.7 per cent in 1998. Moreover, the stock market also plunged by more than 70 per cent during this time, while their currency, the ringgit, depreciated to its lowest level in January 1998.
These are indeed important details for Pakistan to learn from, which is also suffering from an acute balance of payments/financial crisis, where prolonged use of tight monetary policy has not allowed country to grow and caused domestic debt to balloon, while the external debt has seen sharp increase at the back of virtually non-interventionist policy of SBP leading to fast slide of Rupee. The negotiated EFF programme has similar policy prescriptions to what Malaysia followed initially in the financial crisis of late 1990s, only to meet disastrous consequences. Shouldn’t the economic authorities not take a second look at the programme in the light of the Malaysian experience?
In fact, Pakistan should look into how Mahathir Mohamad, PM of Malaysia back then as well, took the country away from pro-cyclical IMF macroeconomic policies. He centralised policies decision-making, by forming in early 1998 a ‘National Economic Action Council’. The recovery plan thus launched was an alternate to orthodox IMF policies. Objectives here included, stabilising local currency, restoring the confidence of financial market and stabilising it, and restructuring corporate debt, among others.
To counter recession, similar to the low economic growth in Pakistan, the policy rate was reduced gradually- from 11 per cent in July 1998 to six per cent by May 1999, and which by the end of 1999 to three per cent. Statutory reserve requirement was also lowered, and the time duration for non-performing loans was restored to the previous six-month level. Most importantly, to deal with foreign exchange slide, among other steps– including introducing capital controls– Mahathir fixed the exchange rate at $1 to RM3.8 in September 1998. All of these policies led to the start of recovery in 1999, and capital controls were relaxed over time, and the pegged Ringgit was switched in July 2005 to a managed-float system.
Although, Pakistan may not fix the exchange rate given the huge current account deficit and low foreign exchange reserves situation, along with high external debt servicing requirement, yet thinking on the lines indicated above should lead to adopting both a managed float, and capital controls.