MODULE 5
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MONETARY POLICY
AND MONETARY
MANAGEMENT
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FINANCIAL SECTOR
INTRODUCTION
An important component of economic policy of the country is to
develop dynamic domestic financial sector to channelize domestic
savings into potential investment for economic development and
growth of the country.
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FINANCIAL SECTOR
FINANCIAL SECTOR
Our financial sector consist of;
Commercial banks
Microfinance banks
Development finance institutions
Insurance companies
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FINANCIAL SECTOR
Development of Banking Sector
At the time of partition;
No central bank
In the areas of Pakistan (east & west) only 213 functioning
branches of scheduled banks exists whereas, united India had
3496 branches.
After partition, State bank of Pakistan began operations on 1 st
July 1948.
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FINANCIAL SECTOR
State bank of Pakistan (SBP) was assigned;
Note issuing authority
Establishment of a banking system
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FINANCIAL SECTOR
In the first 18 months after SBP establishment;
51 new branches were opened in Pakistan
28 branches of Pakistani banks
Commercial banks were asked to extend their areas of
operations
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FINANCIAL SECTOR
According to SBP, banks deposits growth was impressive (61%)
during 1948-54, due to;
Economic revival and industrial development
Consolidation of banking system
Inflow of capital from other muslin countries
Favorable balance of payment
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FINANCIAL SECTOR
Nationalization of Banking sector;
Bank nationalization ordinance was promulgated in 1974.
The federal government had exclusive rights of ownership,
management and control of all the banks in country.
Shareholders were compensated with federal bonds repayable.
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FINANCIAL SECTOR
FINANCIAL SECTOR
Nationalization of banks fulfilled some socio economic objectives
such as opening of new branches in every township almost.
Nationalized banks under political influence gets overstaffed and
overcrowded.
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FINANCIAL SECTOR
ISLAMIC FINANCING
In September 1977, council of Islamic ideology (CII) was asked
to develop the blue print for an interest free economic system.
CII recommends removal of interest from domestic financial
institutions
Government (1979) announced the intentions to remove the
interest from the economy with in three years.
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FINANCIAL SECTOR
1981
All five nationalized banks set up separate counters for interest free
profit and loss sharing deposits.
Three Islamic modes of financing were launched;
Musharakah
Mudarabah
Muarhabah
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FINANCIAL SECTOR
Development after structural adjustment program 1988;
Numerous dramatic changes
Liberalization and denationalization
Opening up of the sector
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MONETARY POLICY
Monetary policy has serious implications for economic
development of country
It is concerned with the regulation of the quantity, cost and
allocation of money and credit in the country.
It determines the allocation of the resources in different sectors.
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Monetary Policy
State bank of Pakistan was granted considerable autonomy to
determine the interest rate and make decisions.
However,
It has been criticized that decision are taken with non technical
factors due to;
Political pressure
Other considerations
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Prior to financial sector reforms of 1991
National credit consultative council (NCCC) was established in
1972, under banking sector reforms.
Distribution of credit
NCCC become the government main source of monetary policy
management.
Govt. debt management program was considered
Poorly managed
Highly unorganized
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FINANCIAL SECTOR
Prior to financial sector reforms of 1991
An annual credit plan was devised each year the determine the
extent of monetary expansion and allocation of credit.
The main mechanism of monitory management was the control
of the volume, cost and allocation of credit (1972-1991)
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FINANCIAL SECTOR
Financial sector has undergone an major transformation since
1991.
Reforms under Financial Sector Adjustment loan(FSAL) and
various structure adjustment programs have changed the nature
of our fiscal, financial & monetary sector.
IMF and World Bank suggested a drastic restructuring of the
financial system due to numerous problems.
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Monetary Management
According to IMF monetary management through quantitative
methods results in “ inefficiency” and “misallocation of resources”
So,
It suggested shift to market based management of monetary policy.
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FINANCIAL SECTOR
REFORMS
Removal of distortion and segmentation
Determination of market based interest rate..
Allocation of credit in response to market forces.
Development of secondary market for Govt. securities.
Increasing autonomy and accountability of national banks.
Allowing private banks to enter the market.
Improving supervision of all financial institutions.
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FINANCIAL SECTOR
MEASURES TAKEN
Full-fledged system of auctioning government debt started in
1991.
System of credit ceiling was discontinued in July 1992.
Open market operations became the major instrument of
monetary management from January 1995
Removal of maximum lending rate.
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The main objective of the Govt. has been to establish a market
determined money market as per the advice of IMF and World
Bank.
Instruments of primary and secondary market are traded to
regulate money, credit and interest rate.
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FINANCIAL SECTOR
So many reforms have taken place since 1992
Opening of banking sector to private sector
Decontrol of interest rate from government intervention
Expansion of financial sector
Improvement in the services of financial institutions
Greater reliance on market forces of monetary management
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FINANCIAL SECTOR
BUT
The united nation economic and social commission for Asia and the
pacific (UNESCAP) has criticized the imposition of structural
adjustment programs in the region.
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Some possible consequences as per report
Increased reliance on market mechanism is not complete
solution of market failure.
Possibility of greater macro economic instability by opening of
capital market.
Banking industry in third world has generally oligopolistic
structure
Emerging banking and financial institution in private sector cater
the need of mostly urban sector.
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Analysis as per report
Reforms should ultimately have positive impact on the real
economy.
The performance of financial sector is directly related to the
level of country’s development.
The actual role of financial sector is keep low cost of borrowing
for financial resources, while encouraging savings.
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Reforms have helped a lot to banking sector for increasing their
profits and credit expansion.
Nevertheless,
At least two areas still lack reforms;
Interest is still controlled.
A secondary market… market oriented money market has not
fully developed.
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MONETARY EXPANSION
Total Monetary Assets;
M1 consists of currency in circulation and demand deposit
M2 consist of M1 plus saving deposits
M3 consist of M2 plus time deposits
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MONETARY EXPANSION
Trends in monetary expansion
Domestic credit expanded a great deal between 1993 to 1998,
in which private sector took a lead
Government budgetary borrowing has also grown too much
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MONETARY EXPANSION
1980’s
Shifts from time deposits to national saving schemes for better
return.
Consequently,
Decline in bank deposit ratio.
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INFLATION TRENDS
Pakistan publish four different price indices
Consumer Price index (CPI)
Whole sale Price Index (WPI)
Sensitive Price index (SPI)
GDP deflator
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INFLATION TRENDS
1961-1988
Real money balances have contributed to the acceleration of
inflation (Akhtar Hussain)
Whereas, govt expenditure financial led by bonds have
negatively effected to inflation growth.
Moreover, irresponsible polices of the govt. also added to
inflation late 80’s
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1990’S (double digit inflation)
Pasha et al. examined all the reasons advanced by various
scholars and classify the key policy variables in their empirical
examination has demand management policies.
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Supply Shocks
If there is crop failure due to external or weather factor results in
less supply of commodities and stimulate inflation
Monetary policy
Increase in money supply dew to budget deficit will push the prices
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Rise in international prices
High tariffs
Devaluation
=
Domestic prices rise
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Pricing policy
High procurement prices
Prices of utilities
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Tax Policy
Rise in tax rates (Sales, Excise etc.)
Expectations
Expectation of the people regarding inflation behavior in future
have key consequences on actual inflation rate.
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1990’s (Key factors explaining inflation in Pakistan)
Procurement prices of wheat
Administered prices of Fuel, Gas and Electricity
Rise in indirect taxes
Devaluation of Pakistani rupee
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Decline in inflation after 1998
Aggregate Demand decreased
Nuclear Test
Military Government
Incident of 9/11
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External factors
Inflation since 2007/8
Chronic inflation
Double digit inflation (comparing with other countries of the
region)
Stuck near about 20% p.a
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Oil prices raise in international market
Global recession
Food price rise in international market
Global diversion of food stuff from consumption to production of
biofuels
Low production due to climate change and other factors
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Support prices of wheat and Rice
Floods of 2010 and 2011
Reduced supply of food stuff and hence impact on prices
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Analysis
Besides the external & domestic factors for this high inflation
there is strong factor of mismanagement on the part of
government due to domestic political factors.
Structural Adjustment Program (IMF & World Bank) also
contributed to recent years high inflation
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LOW SAVINGS RATE
Pakistan’s national savings rate is quite low as compared to other
comparable economies where it is around 20%.
Our savings rate remains volatile over the time.
1970’s …savings rate 11.2%.
1980’s….savings rate 14.8%
Fall again in 1990’s …rise again 2000s.
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Low savings rate is our basic structural macroeconomic problem.
Sources;
Households
Private enterprise sectors
Government savings
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TWO schools of thought;
Financial Repression School
Financial Structure School
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According to Financial Repression School, main obstacle to
savings;
Low or negative real interest rate
Variable inflation rate
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According to Financial Structure school;
Underdeveloped countries use to have lack of depth and breadth in
the financial sector.
Few financial assets
Few institutions
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In case of Pakistan’s low savings rate and its probable causes,
both school of thought supported.
Generally, increase in real interest rate will stimulate aggregate
savings.
More financial development will increase savings rate.
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In 2004,
Low rate of Inflation
Low /negative real interest rate
Results
Increased people borrowing and speculation in stock
market and real estate market.
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In 2008-2012
High inflation rate
Low interest rate
Results
Fall in savings
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LOW SAVINGS RATE
• The low savings rate in Pakistan is the big hindrance to
economic expansion of the country.
• Several studies have been conducted in Pakistan to investigate
the factors behind low savings rate in the country.
• These analyses quoted variety of complicated reasons for this
low savings rate in Pakistan.
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LOW SAVINGS RATE
Research Studies
“As income increases, savings will also increase” (Siddique &
Siddique)
“There is a strong negative effect of dependency ratio on savings”
(zafar Iqbal)
“Foreign financial inflows may discourage domestic public/private
saving behavior and resource mobilization effects” (Shabbir &
Mahmood”
“Foreign capital outflows and foreign interest rate have a “strong
negative” effect on household savings” (Zafar Iqbal)
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LOW SAVINGS RATE
Why the savings rate in Pakistan is very low
Real rate of return on financial assets
Lack of use of formal financial institutions
Foreign financial inflow (foreign aid & foreign capital)
Inflation & uncertainty
Access to financial institutions and instruments
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LOW SAVINGS RATE
Why the savings rate in Pakistan is very low.
Other factors;
Cultural factors
Savings at home
Very large informal financial sector
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LOW SAVINGS RATE
Access to finance survey
According to study only half of the population saves in formal
financial institutions.
14.9% savers go to formal financial institutions.
Around 63.6 % people save at home.
Main purpose of saving is not investment but consumption
smoothing.
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LOW SAVINGS RATE
After examining large number of causative factors for low
savings rate, both schools of thought does not provide adequate
explanation.
Cultural factors too explains low savings rate in country.
