College Research Papers and Essays

SBP Autonomy: Threat or an Opportunity for the Financial Sector?

Note: This is an essay I wrote for Meboob-ul-Haq Economics Society. It was a scam, they never got back to me about it, however, I got some really interesting points out of it, so it'd be a shame to not publish it. 

Allowing the central bank to independently develop and implement policies suitable for the economy, thus deflecting short-term expansionary policies by the government, is known as central bank autonomy. (Erdogan & Büyükakın, 2005). This idea was first introduced to tackle high inflation caused by the Oil Crisis in the 1980s. Various studies have concluded that countries with stronger central bank autonomy experience lower inflation without damaging real growth. (Papi, 2005; Grilli et al., 1991). Cukierman, Neyapti, and Web (1992) have highlighted that in developed countries there is a clear inverse relationship between inflation and judicial autonomy, however, developing countries lack such an association. It has been successful in developed countries due to their existing economic stability that allowed them to focus solely on inflation, Pakistan does not have that sort of luxury so this policy may become counter-productive.

The independence of the central bank is beneficial for a country since it eliminates time inconsistency which reduces inflationary bias, decreases the real interest rate, and moderates demands for increase in wages and prices. (King & Luksetich, 2001; Oatley, 1999). While there is evidence that autonomy contradicts growth and unemployment, Pakistan must focus on controlling inflation. Inflation was recorded at 10.9% in May 2021 making it an urgent matter to address. Autonomy of the state bank is a precondition for stable growth performance since it has a progressive effect on real GDP volatility in the country, thus stabilising the growth path once policy reform takes effect. (Orhan & Yidrim, 2009). Expansionary policies set by the government of Pakistan have led to an increase in growth and employment in the short-run while having disastrous implications of hyperinflation and high interest rates in the long-run. This problem can be tackled by giving the State Bank of Pakistan (SBP) complete autonomy. The effect of independence is strong at muted levels of corruption and vice versa, since Pakistan has ranked 124/180 on the Corruption Perceptions Index 2020, it is crucial that the central bank be given as much independence from the government as possible to allow this policy to succeed. (Griffin, 2010). Conversely, it can be argued that corruption exists within the central bank as well because their policy rate of 13.25% that led to a decline in GDP growth rate, an increase in unemployment interest on debt in 2019-20, indicates the pursuit of money over the greater good. It must be noted, though, that this policy was implemented under government supervision, perhaps changing the hierarchy once SBP becomes autonomous will change its motivation.

There may also be a clash of interest between SBP and the government since the fiscal policies set by the government will be independent of SBP's monetary policy, resulting in poor coordination. For instance, if the government is reducing taxes but the central bank is raising interest rates, the mismatch will undermine both sides' efforts. The central bank in Zimbabwe did little to restraint the monetary policy of the government after it became independent. Their policy reform failed because of the absence of a functioning accountability system and lack of constraints on politicians (Steinberg & Walter, 2013). In contrast, Germany achieved a low inflation rate and high growth rate after giving its central bank complete autonomy because of effective policies applied on time, and the support extended by the citizens and the government. (Orhan & Yidrim, 2009). In Pakistan's case, the amendments state that the SBP governor and administration will not be liable to any political entity, providing them immunity from political influence, however, this does not mean that they will be completely unaccountable, as speculated. The SBP will be answerable to the IMF, and the president of Pakistan has the right to appoint a new governor once the previous one's tenure has ended. Nevertheless, like Germany's central bank, SBP will need government cooperation, it cannot single-handedly control nor stabilize prices as only core inflation falls in its domain while administering prices is in the federal and provincial governments' domain.

Poor coordination is further evident in one of the amendments that states that SBP shall not extend any direct credit to the government of Pakistan. Rural Credit Fund, Industrial Credit Fund, and many others will be abolished (Haq & Gul, 2021). As such, the government will either revise its expenditure or increase taxes. Once the inflation control policies are set in place, the finance sector may initially suffer stunted growth rate and unemployment before reaching stability, a policy such as an increase in taxes may put further burden on the financial sector. Furthermore, if the government is incapable of meeting its revenue targets it will have to take loans at higher interest rates from commercial banks to repay debt, leaving little to no balance for the private sector's economic development. Many financial institutions, including smaller banks, may collapse as the revisions prohibit the government from offering safety-nets for short-term relief to commercial banks facing financial stress (Anwar, 2021). At first glance this situation may seem like a threat, but it could lead to a more competitive market system. Commercial banks would have to compete against foreign banks thus would be forced to raise their standards and improve loan policies leading to more business opportunities for the finance sector. The government's ability to borrow funds to provide salaries and pensions to government personnel and the military can be obstructed by the SBP's governor or its board. Nonetheless, this obstacle can be an opportunity to revise the bureaucracy and funds allocation. In case of a crisis where the government needs SBP's financial support, SBP can violate constitutional provisions and provide an exception. (Haq & Gul, 2021)

Autonomy of institutions is crucial for a country's development; the government alone cannot keep the economy stable nor provide such a large population with new financial opportunities the way multiple autonomous bodies can. China's first step towards development was giving independence to its financial institutions, similarly, Pakistan must start somewhere and making the SBP autonomous is a good start towards prosperity and development.

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References

Anwar, D. T. (2021). Central bank independence: consequences for the economy. Islamabad: The Express Tribune.

Cukierman, A., Neyapti, B., & Web, S. B. (1992). Measuring the independence of central banks and its effect on policy outcomes. The World Bank Economic Review, 353-398.

Erdogan, S., & Büyükakın, F. (2005). The effectiveness of alternative monetary policy strategies: An essay of comparison guide. latest advances in monetary theory and policy symposium II. Muğla University.

Griffin, C. H. (2010). The external impacts of central bank independence. Revista Contabilidade and Finances 21, 51-63.

Grilli, V., Masciandaro, D., & Tabellini, G. (1991). Political and monetary institutions and public financial policies in the industrial countries. Economic Policy, 341-392.

Haq, N., & Gul, A. (2021). The autonomy of State Bank: A fresh look at central bank independence. Pakistan Institute of Development Economics. Islamabad: Pide.

King, B., & Luksetich, W. A. (2001). Central bank independence, economics freedom, and inflation rates. Economic Inquiry, 149-161.

Oatley, T. (1999). Central bank independence and inflation: Corporatism, partisanship, and alternative indices of central bank independence. Public Choice, 399-413.

Orhan, A., & Yidrim, C. D. (2009). The effect of central banks independence on growth volatility: A pooled regression analysis. Serbian Journal of Management, 157-167.

Papi, L. (2005). Central bank autonomy without monetary policy. Transition Studies Review, 3-18.

Steinberg, D., & Walter, S. (2013). The political economy of exchange-rate policy. Handbook of Safegaurding Global Financial Stability.