Similarities and Differences in inflation between Pakistan and India…

Shahid Kardar, Governor of the State Bank of Pakistan gives a superb speech on the inflation trends and its underlying causes in Pakistan. Before I discuss the speech, I must mention that the Central Bank has a decent website with nice working papers.

Ok now to the speech. Kardar talks about three conceptual issues on inflation:

before I get into the specifics of inflationary phenomenon in Pakistan and discuss the rationale for SBP’s current monetary policy stance, I would like to discuss three conceptual points. First, the process of price determination at the basic level. Second, the behavior of inflation. Third, understanding the trade-offs faced by policy makers. This discourse would not only help us in appreciating the scope and effectiveness of monetary policy but also the limits and constraints faced by the State Bank in achieving its objectives.

On first issue of price determination he looks at both micro and macro level. At micro level role of productivity is important. If productivity does not rise, prices will only rise:

If the productivity is low and declining, then the final price tends to be higher even if the cost of acquiring the factors of production remains the same. Put differently, the price can be kept stable or even reduced by increasing the productivity of workers and better and efficient use of technology. The monetary policy stance geared towards containment of overall inflation and thus stability of prices eases the pressures on the cost of production but cannot increase the productivity. Factors positively influencing productivity include stable law and order conditions, a healthy and skilled labor force, effective governance, and uninterrupted availability of energy.

At macro level, three factors matter:

i)- expectations about the continuation of inflationary trends; ii)- the output gap or the difference between aggregate domestic demand and the ability and capacity of the economy to meet that demand; and, iii)- cost push or supply shocks.

Am not discussing these as so much has been written already on them.

Then he talks about policy trade-offs. He looks at mon pol, fiscal policy and exchange rate. I am again not going into it.

Finally, on the inflation trend in Pakistan. As Pakistan’s fiscal year starts from July the analysis compares inflation from year-end i.e. June trends.

Against this conceptual backdrop, let’s talk about the specifics of the current high inflation phenomenon in Pakistan and the role of monetary policy in dealing with the issue. In cumulative terms, Pakistan’s economy has experienced an inflation of 66 percent between October 2010 and June 2007. This is almost twice the level of inflation seen during June 2003 and June 2007, which was 36 percent. What makes the last three years so different from the three years before that?

To begin, let’s dissect the inflation data a bit to shed light on this issue, starting with food prices. The behavior of food group, which has a share of 40 percent in the overall Consumer Price Index (CPI), is not much different across these periods. It is true that food prices grew by 88 percent between June 2007 and October 2010 and by 47 percent between June 2003 and June 2007. But, their share in CPI inflation in both these periods is not much different; 56 and 51 percent respectively. Moreover, virtually the same items across these time periods are responsible for 80 percent of food inflation. Key among these are wheat flour, sugar, fresh milk, meat, and vegetables. So, is this food inflation entirely because of “supply shocks”? Is there anything different that can be highlighted?

He says the price rises are not just because of supply shocks. Govt. policies are equally responsible.

For instance, Govt. purchased wheat from domestic prices at higher than international prices. The purchases were financed by banking system. THis in turn led to a lot of cash in the rural economy with higher incomes in hands of people. This led to demand side inflation. Hence, the supply shock became demand shock and led to higher inflation expectations as well.

THis is much similar to India. The govt. keeps raising MSPs and finances its purchases through rise in borrowing program. As banks remain the major subscribers to the borrowing program it is in a way credit to the government. And then it leads to rise in rural incomes and demand pull inflation. Plus you add various govt. poverty programs and you have a bigger demand shock.

The Gov points that fiscal accounts of government have become much worse over the years:

On the other hand, the borrowings of Public Sector Enterprises, which partially explains transfer of subsidies from the government’s budgetary expenditures directly to the power sector entities, grew by 305 percent during October 2010 and June 2007 compared to only 17 percent during 2003 and June 2007. The contribution of this towards growth in money and thus overall inflation should not be discounted. However, even if we exclude the food and energy group prices from CPI, we observe substantial increase in inflationary pressures. Both non-food-non-energy (NFNE) and trimmed measures of core inflation validate this observation. For example, NFNE grew by 58 percent in the last three years compared to 28 percent in the three years before that.

Did the reduction in subsidies help in reducing the fiscal deficit and easing aggregate demand pressure? Unfortunately, it did not happen. In cumulative terms, the fiscal deficit grew by 146 percent in nominal terms during June 2007 and June 2010 compared to 113 percent during June 2003 and June 2007. If we take out the interest payments, which have been mentioned as a factor adding to the fiscal problems, and look at the primary deficit, the fiscal driven aggregate demand pressures look more pronounced. The primary deficit grew by 3182 percent in the last three years compared to an improvement of 140 percent in the three years before that. The same is the case with revenue deficit – the difference between current expenditures and total revenues. This deficit increased by 298 percent compared to only 27 percent respectively.

Thus, there is an unquestionable increase in aggregate demand pressure because of the public sector.

Further the govt is borrowing more for SBP leading to problems for SBP. It has to balance rising inflation with growth. A higher interest rate would crowd out the private sector further.

The reason for the SBP pursuing a relatively “loose” monetary policy is our concern that it would further crowd out the private sector and negatively impact the growth rate. Faced with this trade-off, SBP has been trying to strike a very difficult balance between such considerations. There is no denying that private sector has borne the brunt of required adjustment in the economy and government has considerably crowded out the private sector both through reduced availability and price of credit. Between June 2003 and June 2007 private sector credit cumulatively grew by 162 percent, while it increased by only 24 percent between June 2007 and November 2010. In turn, this has negatively affected the future productive capacity of the economy, making it more difficult to meet the relatively lower aggregate demand and bring inflation down.

Another downside of the heavy presence of the government and its borrowings from the SBP has been the deterioration of the currency to deposit ratio of the banking system. During June 2007 and June 2003, currency in circulation grew by 70 percent and total deposits of the banking system, excluding government deposits, grew by 104 percent. In the following three years, currency in circulation increased by 82 percent while deposits increased by only 40 percent. While currency in circulation has a strong positive relationship with overall inflation, deposits represent the main funding source for the banking system. A decline in deposits tends to have a contractionary effect on market liquidity and puts an upward pressure on market interest rates.

Again some parallels from India. Recently cash with public has grown and deposit growth has not picked up. This has been one of the factors for tight liquidity situation as well. But in India this is more recent and Pakistan it has been going on for three years now. Earlier Pakistan financed this deficit with capital flows which led to stability in inflation, exchange rate etc. Now the flows have declined. SBP tightened the policy rates since 2007 leading to lower inflation:

The situation looks totally different when we look at the period between June 2007 and November 2010. In response to growing demand pressures, SBP had started tightening its monetary policy stance and it did have an effect. Helped by a decline in international commodity prices, the trade deficit grew by only 18 percent during this period. And the reason SBP has continued with this stance is because foreign investments have contracted by 74 percent and NFA declined by 37 percent. In other words, while aggregate demand has declined but so has the ability of the economy to meet this demand and flow of resources from abroad to fill this gap.

Had SBP not responded, the inflation outlook and reserve position of the country would have been worse. For instance, the growth in broad money and thus inflation would have been much higher if the private sector had also continued to borrow unchecked from the banking system along with the public sector. Some observer can comment that availability of cheap credit to the private sector would have added to the productive capacity, helping reduce the output gap. However, given the deterioration in the law and order conditions and energy sector problems in the last three years, it is highly unlikely that investments in the country, by both local and foreign investors, would have grown rapidly. In any case, rising inflation would have made the businesses uncompetitive by increasing the cost of production.

 Finally:

So, what have we learned about the dynamics of inflation in Pakistan? In broad terms, inflationary pressures have been a mix of upward adjustments in administrated prices, a persistence of output gap and inconsistent macroeconomic policies negatively influencing expectations of inflation. Monetary policy has played its part in correcting the macroeconomic imbalances, but other government policies have not been that supportive. The future strategy to control inflation must include coordinated and timely response to changing macroeconomic conditions along with a concerted effort to raise the productive capacity of the economy. Delays in implementing such a strategy would only make the policy trade-offs much more difficult resulting in continuing uncertainty regarding desirable economic outcomes.

This is something which even RBI might say…

Overall, an excellent speech. I even compared the various growth rates in prices with India. There are some differences as Pakistan data is from 2003 onwards and India’s from 2004 onwards (based on new WPI series). Then Pakistan data is based on CPI and India’s on WPI 

  India (based on WPI) Pakistan (based on CPI)
  Jun-04 to Jun-07 Jun-07 to Oct -10 Jun-03 to Jun-07 Jun-07 to Oct -10
Inflation 16.9 23.4 36.0 66.0
Food Articles 23.3 47.9 47.0 88.0
Wheat 33.8 34.7 40.0 120.0
Mfd. Food Products 9.0 29.9    
Sugar -4.5 73.8 46.0 184.0
Petrol 11.9 21.5 72.0 37.0
Diesel 36.6 22.8 90.0 108.0
Electricity 5.8 7.3 5.0 62.0
     Electricity ( Domestic) 3.3 10.5    
     Electricity (Commercial) -3.3 7.2    
Core Inflation 14.0 11.7 28.0 58.0

Prices have increased much faster in Pakistan than India.

However, the surprise bit is fiscal indicators. Kardar says the main reason is improper govt policies which led to higher deficits and higher inflation. But India seems to have fared as bad as Pakistan in terms of rise in deficits:

  India (growth rate in %) Pakistan (growth rate in %)
  Mar-04 to Mar-07 Mar-07 to Mar-10 Jun-03 to Jun-07 Jun-07 to Jun -10
Fiscal Deficit 15.7 190.4 113.0 146.0
Revenue Deficit -18.4 310.2 27.0 298.0
Primary Deficit 844.7 -2626.8 140.0 3182.0

Hence both in terms of revenue and fiscal deficits, India has worse performance than Pakistan in the period 2007-10. Despite this, India has much better inflation performance. What could be the reason?

I could think of a few. First, I have taken WPI for India and may be taking CPI will bring numbers closer to Pakistan. WPI data is far more readily available and hence it was used. Second, RBI has kept a tighter tab on the monetary indicators compared to SBP. Third, there are many differences between Pakistan and Indian economy. India could have lower supply constraints than Pakistan. Fourth, rains could be more volatile in Pakistan compared to India…What else?

Overall, a superb speech. Helps think about many issues not just on Pakistan economy but inflation issues in general as well. A very frank assessment as well.

Advertisements

One Response to “Similarities and Differences in inflation between Pakistan and India…”

  1. Pakistan: On the Verge of an Economic Meltdown? « Mostly Economics Says:

    […] since I learnt about Pakistan economy and its similar inflation trajectory as India’s, it is interesting to read […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.


%d bloggers like this: