Role of State Bank Monetar Policy

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INSTITUTE OF BUSINESS AND TECHNOGY

ROLE OF STATE BANK IN MONETARYPOLICY


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1. INTRODUCTION

Introduction:

In the beginning of the report, I focused the State Bank functions, departments

and responsibilities towards the Economy and the relationship with Governmentof Pakistan.The State Bank of Pakistan also performs both the traditional anddevelopmental functions to achieve macroeconomic goals. The traditionalfunctions, may be classified into two groups, i.e. Primary and Secondary. Beingthe Central Bank of the country, State Bank of Pakistan has been entrusted withthe responsibility to formulate and conduct monetary and credit policy in amanner consistent with the Governments target.

Along with State Bank detailed introduction, the report also includes the briefintroduction of Monetary policy, its types, tools and instruments, objectives,intermediates targets and its limitations. Monetary policy management and

financial sector stability are two primary roles of State Bank of Pakistan (SBP).Monetary policy and process of its formulation in Pakistan has undergonechanges with the evolving economic dynamics within the country and theimproved empirical and theoretical understanding of the monetary policy acrossthe world.

In the middle the report contains the Role of State Bank in Monetary Policy,which includes the transparency in making, transmission, controlling, andcomparison with other Central Banks. This report also contains the SBPresponse through Monetary Policy 2008, the issues which State Bank faced, thewhat Risks and Challenges are involve, and the measure the SBP has taken

along with Implication and Limitations. Apart from the SBP own analysis, thisreport also contains the Independent (external) Analysis, which based onsecondary statical data and various economists views.

In the last part, the 4rth chapter supplemented to discuss the current scenario ofGlobal Financial Crisis, how the State Bank encounters this turmoil by interimissue of monetary policy statements, the measures taken to improve Liquidityand restore stability in the money market and exchange rate. Finally the lastchapter it includes the overall Recommendation with Conclusion.
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1.2 Purpose of Study:

The purpose of this report is to get the knowledge about the Role of State Bankof Pakistan in Monetary Policy. Because being the student of MBA banking &finance I should have the complete idea about the Central Bank of the Country

and its role in the Monetary Policy Management. Why monetary Policy? Becausemonetary policy is the major driving force for financial institutions, money market,capital market as well as the Economic and Financial stability of the country.What is the driving force to choose the monetary policy for the project report?Because I am the full time student and not the part of any formal organization butmy father work for State Bank and just because of him I could easily access toMonetary Policy Division of SBP and its personnel directly.

Basically the purpose of this study is to understand that how central bankformulate, implementation (transmission) of Policy, the challenges and risk areinvolve, and how they use their different tools in varied economic conditions.

Apart from these, in the light of external analysis about what those factor whichcreates trouble for them after taking all preventive measures and projections forfuture.

Secondly the how global crunch is affecting Pakistan, the proactive approachwhich state bank adopted to restore the exchange rate, control inflation, stabilityof Financial Institutions, liquidity and ultimately the overall macroeconomicgrowth. Unfortunately the monetary policy in Pakistan had long remaineddormant to play its true role in macroeconomic management and was madehostage to fiscal policy to give coverage to persistent fiscal indiscipline.Abstracting from the little discussion of emerging complications for Asia, Ipropose to now concentrate on Pakistan

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1.3 Research Objective:

There are following research objectives listed on the basis of priority.

Independence and Transparency Analysis of State Bank of Pakistan incomparison with other Central Banks.

Global Financial Crisis and State Banks measures, withrecommendations.

Functions and Responsibilities of State Bank of Pakistan.

Monetary Policy?


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1.4 Research Methodology:

We employ the Eijffinger and Geraat (2007) independent analysis approach tomeasure monetary policy transparency of the State Bank of Pakistan. According

to this approach, a questionnaire (see Appendix A) is developed on monetarypolicy issues and the researcher independently answers the questions based oninformation gleaned from various central bank documents like reports on thestate of the economy, monetary policy statements, and speeches of the centralbank officials.

The questionnaire elicits information through a set of fifteen questions, with threequestions each on political, economic, procedural, policy and operationaltransparency. Each question has two or three options with a maximum score of1. In case of two options the central bank is awarded either 0 or 1 score but incase of three options there is a middle score of 0.5 (a case of partial

transparency). In aggregating the score, all the questions are given equal weightso on each aspect of transparency a central bank can get a maximum score of 3.

Each type of transparency is also given the same weight so there is nopreference for one type of transparency over the other. In this way a central bankcan get a maximum score of 15. There are at least three important advantages ofusing the Eijffinger and Geraats (2007) index. First, unlike survey-basedtechniques, this index is based on an independent analysis (by the researcher) ofmonetary policy practices.

This is important because in surveys, respondents (central bankers) may havean incentive to falsely portray a favorable scenario of monetary policytransparency. Second, the index covers almost all the aspects of monetary policyand hence presents a broader measure of transparency as compared with otherworks that have focused on only two or three aspects. Third, the index is notrestricted to any particular type of monetary policy framework e.g. inflationtargeting, monetary targeting etc.


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2. STATE BANK OF PAKISTAN

2.1 Introduction to Central Bank:

It is a bank, which is responsible for the financial and economic stability ofcountry. The bank is a symbol of its sovereignty and solidarity. Every country,whether developed or not, capitalist or otherwise must have a central bank. It hasa pivotal position in the banking system and regulates and formulates policies forthe scheduled commercial banks in a country. In Pakistan the central bank isknown as State Bank of Pakistan.

The Origin of central banking system can be traced back to 1694 when the Bankof England came into being as the first ever central bank. In the beginning the

central bank was mainly confined only to issuing paper currency, but at laterstages it was entrusted with other crucial functions like credit control, clearinghouse management of public debts, rediscounting of bills, custodian of foreignexchange, and the like. Now a central bank has become a must for every countryand its economy. It control other banks, DFIs, inflation, formulates economic,Fiscal and monetary policy and advises the government on foreign trade,development of financial and capital markets, balance of trade, foreign aids etc.

The world has turned into a global village, every country being increasinglydependent on one another. Consequently, it has not only augmented the role of acentral bank but also necessitated the establishment of a world central bank that

regulates the function of all central banks under the sun. Hence, the World Bank(IBRD) and International Monetary Fund (IMF) have come into being exercisingtheir full control all central bank, especially those in the Third World Countries.Even, an international currency named Special Drawing Rights (SDR) has beenevolved. Every country, being the member of the UN, has no option except tofollow the dictates of the IMF and the World Bank.

History:

The State Bank of Pakistan (SBP) (Urdu: ) is the central bank ofPakistan. While its constitution, as originally laid down in the State Bank of

Pakistan Order 1948, remained basically unchanged until January 1, 1974,when the bank was nationalized, the scope of its functions was considerablyenlarged. The State Bank of Pakistan Act 1956, with subsequent amendments,forms the basis of its operations today. The headquarters are located in thefinancial capital of Pakistan, Karachi withits second headquarters in the capital,Islamabad. Before independence on 14 August 1947, the Reserve Bank ofIndia (central bank of India) was the central bank for what is now Pakistan. On30 December1948 the British Government's commission distributed the Bank of
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India's reserves between Pakistan and India - 30 percent (750 M gold) forPakistan and 70 percent for India.

The losses incurred in the transition to independence were taken from Pakistan'sshare (a total of 230 million). In May, 1948 Muhammad Ali Jinnah (Founder of

Pakistan) took steps to establish the State Bank of Pakistan immediately. Thesewere implemented in June 1948, and the State Bank of Pakistan commencedoperation on July 1, 1948 Muhammad Ali Jinnah on 1st July 1948 at theopening of the State Bank of Pakistan

Under the State Bank of Pakistan Order 1948, the state bank of Pakistan wascharged with the duty to "regulate the issue of bank notes and keeping ofreserves with a view to securing monetary stability in Pakistan and generally tooperate the currency and credit system of the country to its advantage".

A large section of the state bank's duties were widened when the State Bank of

Pakistan Act 1956 was introduced. It required the state bank to "regulate themonetary and credit system of Pakistan and to foster its growth in the bestnational interest with a view to securing monetary stability and fuller utilisation ofthe countrys productive resources". In February 1994, the State Bank was givenfull autonomy, during the financial sector reforms.

On January 21, 1997, this autonomy was further strengthened when thegovernment issued three Amendment Ordinances (which were approved by theParliament in May 1997). Those included were the State Bank of Pakistan Act,1956, Banking Companies Ordinance, 1962 and Banks Nationalisation Act,1974. These changes gave full and exclusive authority to the State Bank toregulate the banking sector, to conduct an independent

monetary policyand to

set limit on government borrowings from the State Bank of Pakistan. Theamendments to the Banks Nationalisation Act brought the end of the PakistanBanking Council (an institution established to look after the affairs of NCBs) andallowed the jobs of the council to be appointed to the Chief Executives, Boards ofthe Nationalised Commercial Banks (NCBs) and Development FinanceInstitutions (DFIs). The State Bank having a role in their appointment andremoval. The amendments also increased the autonomy and accountability ofthe chief executives, the Boards of Directors of banks and DFIs.

The State Bank of Pakistan also performs both the traditional and developmentalfunctions to achieve macroeconomic goals. The traditional functions, may beclassified into two groups:

The primary functions including issue of notes, regulation and supervision of thefinancial system, bankers bank, lender of the last resort, banker to Government,and conduct of monetary policy.The secondary functions including the agency functions like management ofpublic debt, management of foreign exchange, etc., and other functions like
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advising the government on policy matters and maintaining close relationshipswith international financial institutions.

The non-traditional or promotional functions, performed by the State Bankinclude development of financial framework, institutionalisation of savings and

investment, provision of training facilities to bankers, and provision of credit topriority sectors. The State Bank also has been playing an active part in theprocess of islamisation of the banking system.

2.2 Fundamental & Core Functions:

The functions of a central bank can be placed in two broad categories:1) Governments Bank.2) Bankers Bank.

As a governments bank, the central bank performs the following functions:

1. Monopoly of note issue.2. Controller of Credit.3. Custodian of Foreign exchange.4. Issue and Management of Public debts.5. Development of financial institutions.6. Implementing Monetary Policy

The central banks also act as bankers bank. In this capacity it performs valuableservices to its scheduled commercial banks. These indispensable services are asunder.1. Lender of the resort.

2. Rediscounting of the bill of exchange.3. Clearing House Services.4. Cash Reserves.5. Counseling Services.6. Regulating and Supervising the Banking Industry.

Core Functions of State Bank:

State Bank of Pakistan is the Central Bank of the country. While its constitution,as originally laid down in the State Bank of Pakistan Order 1948, remainedbasically unchanged until 1st January 1974 when the Bank was nationalized, the

scope of its functions was considerably enlarged. The State Bank of Pakistan Act1956, with subsequent amendments, forms the basis of its operations today.

Under the State Bank of Pakistan Order 1948, the Bank was charged with theduty to "regulate the issue of Bank notes and keeping of reserves with a view tosecuring monetary stability in Pakistan and generally to operate the currency andcredit system of the country to its advantage". The scope of the Banksoperations was considerably widened in the State Bank of Pakistan Act 1956,


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which required the Bank to "regulate the monetary and credit system of Pakistanand to foster its growth in the best national interest with a view to securingmonetary stability and fuller utilization of the countrys productive resources".

Under financial sector reforms, the State Bank of Pakistan was granted

autonomy in February 1994. On 21st January 1997, this autonomy was furtherstrengthened by issuing three Amendment Ordinances (which were approved bythe Parliament in May, 1997) namely, State Bank of Pakistan Act, 1956, BankingCompanies Ordinance, 1962 and Banks Nationalization Act, 1974. The changesin the State Bank Act gave full and exclusive authority to the State Bank toregulate the banking sector, to conduct an independent monetary policy and toset limit on government borrowings from the State Bank of Pakistan. Theamendments in Banks Nationalization Act abolished the Pakistan BankingCouncil (an institution established to look after the affairs of NCBs) andinstitutionalized the process of appointment of the Chief Executives and Boardsof the nationalized commercial banks (NCBs) and development finance

institutions (DFIs), with the Sate Bank having a role in their appointment andremoval. The amendments also increased the autonomy and accountability ofthe Chief Executives and the Boards of Directors of banks and DFIs.

Like a Central Bank in any developing country, State Bank of Pakistan performsboth the traditional and developmental functions to achieve macro-economicgoals. The traditional functions, which are generally performed by central banksalmost all over the world, may be classified into two groups: (a) the primaryfunctions including issue of notes, regulation and supervision of the financialsystem, bankers bank, lender of the last resort, banker to Government, andconduct of monetary policy, and (b) the secondary functions including the agency

functions like management of public debt, management of foreign exchange,etc., and other functions like advising the government on policy matters andmaintaining close relationships with international financial institutions. The non-traditional or promotional functions, performed by the State Bank includedevelopment of financial framework, institutionalization of savings andinvestment, provision of training facilities to bankers, and provision of credit topriority sectors. The State Bank also has been playing an active part in theprocess of islamization of the banking system. The main functions andresponsibilities of the State Bank can be broadly categorized as under.

2.3 Responsibilities

Regulation of Liquidity

Being the Central Bank of the country, State Bank of Pakistan has beenentrusted with the responsibility to formulate and conduct monetary and creditpolicy in a manner consistent with the Governments targets for growth andinflation and the recommendations of the Monetary and Fiscal Policies Co-ordination Board with respect to macro-economic policy objectives. The basicobjective underlying its functions is two-fold i.e. the maintenance of monetary


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stability, thereby leading towards the stability in the domestic prices, as well asthe promotion of economic growth.

To regulate the volume and the direction of flow of credit to different uses andsectors, the Bank makes use of both direct and indirect instruments of monetary

management. Until recently, the monetary and credit scenario was characterizedby acute segmentation of credit markets with all the attendant distortions.Pakistan embarked upon a program of financial sector reforms in the late 1980s.A number of fundamental changes have since been made in the conduct ofmonetary management, which essentially marked a departure fromadministrative controls and quantitative restrictions to market-based monetarymanagement. A reserve money management program has been developed. Interms of the program, the intermediate target of M2 would be achieved byobserving the desired path of reserve money - the operating target. While use innow being made of such indirect instruments of control as cash reserve ratio andliquidity ratio, the programs reliance is mainly on open market operations.

Ensuring the Soundness of Financial System

One of the fundamental responsibilities of the State Bank is regulation andsupervision of the financial system to ensure its soundness and stability as wellas to protect the interests of depositors. The rapid advancement in informationtechnology, together with growing complexities of modern banking operations,has made the supervisory role more difficult and challenging. The institutionalcomplexity is increasing, technical sophistication is improving and technical baseof banking activities is expanding. All this requires the State Bank forendeavoring hard to keep pace with the fast-changing financial landscape of thecountry. Accordingly, the out dated inspection techniques have been replacedwith the new ones to have better inspection and supervision of the financialinstitutions. The banking activities are now being monitored through a system ofoff-site surveillance and on-site inspection and supervision. Off-sitesurveillance is conducted by the State Bank through regular checking of variousreturns regularly received from the different banks. On other hand, on-siteinspection is undertaken by the State Bank in the premises of the concernedbanks when required.

To deepen and broaden financial markets as also to diversify the sources ofcredit, a number of non-bank financial institutions (NBFIs) were allowed toincrease substantially. The State Bank has also been charged with theresponsibilities of regulating and supervising of such institutions. To regulate andsupervise the activities of these institutions, a new Department namely, NBFIsRegulation and Supervision Department was set up. Moreover, in order tosafeguard the interest of ultimate users of the financial services, and to ensurethe viability of institutions providing these services, the State Bank has issued a


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comprehensive set of Prudential Regulations (for commercial banks) and Rulesof Business (for NBFIs).

The "Prudential Regulations" for banks, besides providing for credit and riskexposure limits, prescribe guide lines relating to classification of short-term and

long-term loan facilities, set criteria for management, prohibit criminal use ofbanking channels for the purpose of money laundering and other unlawfulactivities, lay down rules for the payment of dividends, direct banks to refrainfrom window dressing and prohibit them to extend fresh loan to defaulters of oldloans. The existing format of balance sheet and profit-and-loss account has beenchanged to conform to international standards, ensuring adequate transparencyof operations. Revised capital requirements, envisaging minimum paid up capitalof Rs.500 million have been enforced. Effective December,1997, every bank wasrequired to maintain capital and unencumbered general reserves equivalent to 8per cent of its risk weighted assets.

The "Rules of Business" for NBFIs became effective since the day NBFIs cameunder State Banks jurisdiction. As from January 1997, modarbas and leasingcompanies, which are also specialized type of NBFIs, are beingregulated/supervised by the Securities and Exchange Commission (SECP),rather than the State Bank of Pakistan.

Exchange Rate Management & Balance of Payment

One of the major responsibilities of the State Bank is the maintenance of externalvalue of the currency. In this regard, the Bank is required, among other measurestaken by it, to regulate foreign exchange reserves of the country in line with thestipulations of the Foreign Exchange Act 1947. As an agent to the Government,the Bank has been authorized to purchase and sale gold, silver or approvedforeign exchange and transactions of Special Drawing Rights with theInternational Monetary Fund under sub-sections 13(a) and 13(f) of Section 17 ofthe State Bank of Pakistan Act, 1956.

The Bank is responsible to keep the exchange rate of the rupee at an appropriatelevel and prevent it from wide fluctuations in order to maintain competitiveness ofour exports and maintain stability in the foreign exchange market. To achieve theobjective, various exchange policies have been adopted from time to timekeeping in view the prevailing circumstances. Pak-rupee remained linked toPound Sterling till September 1971 and subsequently to U.S. Dollar. However, itwas decided to adopt the managed floating exchange rate system w.e.f. January8, 1982 under which the value of the rupee was determined on daily basis, withreference to a basket of currencies of Pakistans major trading partners andcompetitors. Adjustments were made in its value as and when the circumstancesso warranted. During the course of time, an important development took placewhen Pakistan accepted obligations of Article-VIII, Section 2, 3 and 4 of the IMFArticles of Agreement, thereby making the Pak-rupee convertible for currentinternational transactions with effect from July 1, 1994.


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After nuclear detonation by Pakistan in 1998, a two-tier exchange rate systemwas introduced w.e.f. 22nd July 1998, with a view to reduce the pressure onofficial reserves and prevent the economy to some extent from adverseimplications of sanctions imposed on Pakistan. However, effective 19th May1999, the exchange rate has been unified, with the introduction of market-based

floating exchange rate system, under which the exchange rate is determined bythe demand and supply positions in the foreign exchange market. The surrenderrequirement of foreign exchange receipts on account of exports and services,previously required to be made to State Bank through authorized dealers, hasnow been done away with and the commercial banks and other authorizeddealers have been made free to hold and undertake transaction in foreigncurrencies.

As the custodian of countrys external reserves, the State Bank is alsoresponsible for the management of the foreign exchange reserves. The task isbeing performed by an Investment Committee which, after taking into

consideration the overall level of reserves, maturities and payment obligations,takes decision to make investment of surplus funds in such a manner thatensures liquidity of funds as well as maximizes the earnings. These reserves arealso being used for intervention in the foreign exchange market. For this purpose,a Foreign Exchange Dealing Room has been set up at the Central Directorate ofState Bank of Pakistan and services of a Forex Expert have been acquired.

2.4 Developmental Role of State Bank

The responsibility of a Central Bank in a developing country goes well beyondthe regulatory duties of managing the monetary policy in order to achieve the

macro-economic goals. This role covers not only the development of importantcomponents of monetary and capital markets but also to assist the process ofeconomic growth and promote the fuller utilization of a countrys resources.

Ever since its establishment, the State Bank of Pakistan, besides discharging itstraditional functions of regulating money and credit, has played an activedevelopmental role to promote the realization of macro-economic goals. Theexplicit recognition of the promotional role of the Central Bank evidently stemsfrom a desire to re-orientate all policies towards the goal of rapid economicgrowth. Accordingly, the orthodox central banking functions have been combinedby the State Bank with a well-recognized developmental role.

The scope of Banks operations has been widened considerably by including theeconomic growth objective in its statute under the State Bank of Pakistan Act1956. The Banks participation in the development process has been in the formof rehabilitation of banking system in Pakistan, development of new financialinstitutions and debt instruments in order to promote financial intermediation,establishment of Development Financial Institutions (DFIs), directing the use of


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credit according to selected development priorities, providing subsidized credit,and development of the capital market.

Structure and Operations:

The central directorate of the bank is situated in Karachi. The bank is empoweredto establish branches, offices and agencies in Pakistan or, with the prior approvalof the federal government, anywhere out side Pakistan. The bank started withonly a nucleus organization but its organizational structure has grown rapidly.Apart from the central directorate, there are several offices, which function underthe general guidance and supervision of the Central Directorate. In 2001 SBPestablished a subsidiary, the banking service corporation to oversee the bankingsystems and provide supervision and support services.

The general superintendence and direction of the affairs and business of thebank (and its subsidiary) is vested in a Central Board of Directors comprising of

Governor, Deputy Governors and Directors nominated by the federalgovernment. With the expectation of the government directors, no person can bea director who is the member of federal and provincial legislature, who is salariedgovernment official, who is an officer or employee of any bank, who is a directorof another bank, or who absents himself from three consecutive meetings of theCentral Board without leave. The directors hold office at the pleasure of thefederal government. Meetings of the Central Board are required to be held atleast six times year and at least once every quarter.

The Chief Executive of the Bank is the governor who controls and directs theaffairs of the bank on the behalf of the Central Board. S(he) has full authority to

conduct the business control the functions and manage the affairs of the bank inall matters not specifically required by the act, or by regulation made their under,to be conducted by the Central Board. The governor appointed by the federalgovernment for a term not exceeding five years and on such salary and termsand conditions of service as the federal government may determine. His salaryand other terms and conditions of service cannot be varied to his disadvantageafter appointment. He is also eligible for reappointment, if the government sodesires, on the completion of his term of office. The governor presides at themeetings of the central board. Deputy Governors are also appointed by thefederal government for a period not exceeding five years. There terms andconditions of service cannot be varied to their disadvantage after their

appointment. The Deputy Governors performs such duties as a assigned to themby the central Board and, in the absence of governor, a deputy governor presidesat the meetings of the central board and transacts all business of the bank.

Most State Bank governors have held five year terms. Dr. Yaqub Architect of themarketization of national monetary policy was appointed in 1993 and his term ofoffice was prematurely extended in 1997 by the pro-IMF caretaker administrationof Mr. Mooeen Qureshi. Dr. Yaqub resigned in 1999. executive directorships


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were established in 1965. The executive directors are not director of the boardbut share work with the deputy governor. The co-ordination committee was alsosetup which was the highest policy making body at the executive level. In recentyears, the co-ordination has become non-functional. External advisors especiallythose nominated by the IMF have acquired increased influence as have non-line

advisors appointed by the governor.

The State Banks operational and organizational structure has been consciouslymodeled on that of the bank of England. It has two nationally separatedepartments (the issue departments and the banking department). The latertransacts general banking business, while the former is concerned exclusivelywith the issue of notes. As of 1 June 2002, there were two deputy governors, achief economic advisor to governor, five other advisors to he governor, threeexecutive directors, and eighteen department heads. The banking servicescorporation is headed by a managing director and has eight departments asixteen field offices (previous regional offices of the SBP).

State bank was the sole authority for the issue of notes. Until 1965, it wasresponsible for coins and Rs 1 notes which is now the concern of the federalgovernment. Under the state bank of Pakistan act 1956, the issue of notes wasbases on proportional reserve system. The entire amount representing the notesissued had to be backed by an equivalent amount of assets of which not lessthan 30% was required to be maintained in the form of gold coins, gold bullion,Silver bullion, and approved foreign exchange. The assets were required to beheld in the form of rupee coins, rupee securities, and such bills of exchange andpromissory notes as were eligible for purchase by the bank. The requirementrelating to the maintenance of minimum amount of gold coin, gold and silverbullion, and approved foreign exchange could, however, be suspended by thebank with previous sanctions of federal government, for a period not exceeding20 days in first instance which could be extended from time to time by the periodnot exceeding fifteen days. There was only one occasion on which provision ofsuspension was resorted to during the 1965 Indo-Pakistan War.

The State Bank also acts as banker or to federal and provincial governments.They are required to deposit, free of interest, their cash balances with the bankwhich accept government deposits and cheques or drafts, undertakes thecollection of these cheques and drafts drawn on other bank, and provides cash tothem. It debits their accounts with amount of cheques or voucher drawn by thegovernment on the state bank presented for encashment by other parties. Ittransfers government funds and manages the public debt of the federal as wellas the provincial governments. In places where it does not have its own office,the state bank has appointed the National Bank of Pakistan as its agents toconduct government business. It charges no commission from the governmentfor services rendered and it pays no interest to the government on their balances.The work relation to the government accounts is handled in the public accountsdepartment of the state bank. Apart from the issue of permanent public debt, the


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bank also sells government treasury bills on tap or tender and National PrizeBonds.

The bank makes advances to the federal as well as the provincial governments,which are repayable not latter than three month. These advances are made with

out collateral security. In addition, loans are also guaranteed to provincialgovernments against collateral of federal government securities. The state bankfixes limits for such advances from time to time.

The bank enjoys certain powers permitting it in special circumstances to relaxusual requirements regarding the securities to be lodged by the banks forborrowing from it, and can provide accommodation to them against any securitywhich to consider sufficient. In such special circumstances, the bank can alsodispense with the requirement of providing loans and discount facilities throughscheduled banks, although in the normal conduct of business it is debarred fromhaving such dealings. The state bank is prohibited from undertakings the

following business:

a) To engage in trade or otherwise have direct interest in any commercial,industrial, or other undertaking except such interest as it may in any wayacquire in the course of the satisfaction of any of its claims but also suchinterest shall be disposed of at the earliest possible moments;

b) To purchase its own shares or the shares of any other bank or companyor grant advances or loans upon the security of any such shares;

c) To advances money on the mortgage or on the security of immoveableproperty or documents of titles relating thereto;

d) To become the owner of any immoveable property except whereownership is necessary for the use of the Bank;

e) To make unsecured advances or loans;f) To draw or accept bills payable otherwise than on demand.

The bank collects comprehensive statistical information on money and banking,balance of payments, foreign investment and other allied subjects. It issues aweekly press communiqu on the affairs of the scheduled banks and also aweekly statement of its own affairs, which is statuary responsibility. It alsopublished a monthly bulletin and Annual report. There is a research department,an economic policy department and a statistics department but research output ispoor compared to that of Reserve Bank of India. The state has yet to be publishan economy wide flow of funds table and its analysis of corporate balance sheetdata is usually four years out of date. Much of research undertaken by the StateBank is now geared to serving the primary data needs of the IMF and WorldBank resident missions and is thus of a classified nature-not generally availableto Pakistani Policy-makers and students.

2.5 Relationship with the Government


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Formally the government exercise comprehensive control over the State Bank.The government appoints both the Governor and Deputy Governors. Thegovernment nominates all the directors who serve on the Central Board,including one from among its officials. If in its opinion, the bank fails to carry outany of the obligations imposed on it, the federal government may, by notification

declare the central board to be superseded and thereafter the generalsuperintendence and direction of the affairs of the bank may be entrusted to suchagency as the federal government may determine. In such an event, the federalgovernment would be obliged to make full report of the circumstances leading tosuch action to be laid before the National Assembly.

The federal government is also empowered to remove the Governor or DeputyGovernors from office if their continuance in office as regarded as manifestlyopposed to the interests of the Bank. Under section 44 of the State Bank ofPakistan Act (1956 as amended). The federal Government may, at any timeappoint the Auditor General or such Auditors as it thinks fit examine and report

upon the accounts of the bank. However, in the normal circumstances the termsand condition of service of the Governor and the Deputy Governor cant bechanged to their disadvantage once they are appointed. Once appointed, theycannot be removed from during their tenure except on conditions specially setout in the Act.

Since 1988 there has been increasing pressure on the government to recognizeand enhance the autonomy of the Central Bank. The essence of this autonomylies in the placing of limitations on the government to:

Manage foreign exchange. This means accepting priorities of theinternational money markets and adjusting the national macro-economy to

these preferences; Borrow from the Banking System as a whole;

Borrow from the central Bank.Fixing targets for the government borrowing from the banking system hasapproved more difficult than limiting the governments borrowing from the StateBank.

3. STATE BANKS IN MONETARY POLICY


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3.1 Monetary Policy

Monetary policy is a short-run tool used by the central bank to persist sustainableeconomic growth (in the long-run) by controlling the money supply through openmarket operations, discount lending and reserve requirements.

Before focusing on the significance for and affects of monetary policy on theeconomy of the country, first we discuss what monetary policy is? And how it isused by the central bank?

Monetary policy is the process of managing a nation's money supply to achievespecific goalssuch as constraining inflation, achieving full employment or morewell-being. Monetary policy can involve setting interest rates, marginrequirements, capitalization standards for banks or even acting as the lender oflast resort or through negotiated agreements with other governments.

A wide variety of policy systems are possible to conduct monetary policyoperations, but in the current international scenario, we have two broad groups ofcountries:

The first one is the group of those countries (like Hong Kong, Zambia, and China,etc.), whose monetary policies are focused primarily on the exchange rate. Theyeither has exchange rates fixed to a major international currency (usually U.S.dollar) or in some kind of target band and monetary policy involve themanagement of that exchange rate.

The second is the group of countries with floating exchange rates (like the UnitedStates of America, Japan, Pakistan and Australia, etc.) and monetary policyinvolves the management of short-term interest rates by central banks to pursuethe macroeconomic objectives of the economy.

The central bank uses monetary policy in two ways: that is contractionarymonetary policy or expansionary monetary policy.

The Central Bank designs Contractionary policy in order to constrain the growthof money (i.e. increasing inflation) and credit in the economy. This is done by anincrease in interest rates and a decrease in bond prices, such that higher interestrates lead to lower levels of capital investments, and leading the demand forbonds (domestic) to rise. The appreciation of domestic currency causesexchange rate to rise so there would be an increase in the demand for domesticcurrency and fall in demand for foreign currency. Thus a higher exchange ratecauses a decline in exports and the imports get dearer in the country.

In the present international scenario, due to hike in inflation internationally, mostof the countries adopted contractionary policy, like Pakistan recently hasincreased interest rate by 0.5 percent and set 10 percent short-term interest


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rates, and it is expected that the Reserve Bank of Australia (RBA) would increaseshort-term interest rates from 6.25 percent to 6.50 percent.

On the other hand Expansionary policy is used as a tool by the central bank tobroaden the monetary base and credit in the economy by reduction in interest

rates and increase in bond prices. The reduced interest rates attract capitalinvestments and increased bond prices reduce its demand and the demand forforeign bonds to rise. The exchange rate also lowers down as a result of fall inthe demand for domestic currency and a rise in demand for foreign currencyleading currency to depreciate, resulting imports to decline and export toaccelerate.

In 1999, Ecuador adopted the expansionary monetary policy in, but failed toachieve the required economic growth.

Objectives of Monetary Policy

Price stability, Maintenance of full employment, and The economic prosperity and welfare of the people of the economy.

Price stability, that is controlled price level, is the imperative condition for theconstant economic growth, once accomplished leads to full employment andeconomic prosperity. Price stability develops investors confidence boostinginvestments, causing acceleration of economic activity and achievement of fullemployment.

Thus, the significance of monetary policy is to achieve the inflation target (set bythe central bank for required economic growth), and as a consequence, toaccelerate strong and sustainable economic growth. Achievement of inflationtarget directs strong currency valuation in terms of other foreign currencies,resulting as favorable balance of payments.

Tools of Monetary Policy:

In order to attain the objectives discussed above, the central bank uses threetools: open market operations, the discount rate and reserve requirements.

Open Market Operations: The most effective and major tool the central bank

uses to affect the monetary supply in the economy is open market operations that is, the buying and selling of government securities (usually bonds or T-bills)by the central bank.

If the central bank decides to increase monetary base in the economy it buyssecurities from the open market and pays for these securities by crediting thereserve amounts of banks involved in selling. This will increase the reserveamount the banks hold, such that banks have more money to lend, interest rates


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my fall, leading to increase investment spending and as a result economicgrowth.

Conversely, in order to tighten the monetary base in the economy, the centralbank sell the government securities, as a result collect payments from banks by

reducing their reserve accounts. Having less money in these reserve accountsthe opportunity cost of lending money decline, such that interest rates mayincrease, resulting a drop of investment spending, that is the slow down ofeconomic activity.

The Discount Rate: the rate at which financial institutions may borrow funds forshort-term directly from the central bank. When the central bank reduces thediscount rate, financial institutions must pay to borrow from the central bank;financial institutions become more willing to borrow, to make more moneyavailable for lending to businesses and households at low interest rates. Thiswould initiate more consumption and investment spending and generate

economic activity in the economy. The reverse would be the effect in case ofincreased discount rate.

Reserve Requirements: the proportion of the total assets that banks must holdin reserve with the central bank. Financial institutions only maintain a smallportion of their assets as cash available for immediate withdrawal; the rest isinvested in illiquid assets (like loans and mortgages). The monetary policy can beimplemented by altering the proportion of these required reserves. Increasing theproportion of total assets to be held as liquid cash increases the amount ofmoney available to banks as loanable funds, thus mean the broader monetarybase in the economy, vice versa.

How does Monetary Policy affect the economy of a country?

After having discussed the objectives and tools of monetary policy, let us nowtalk about how policy affects the economy:

Consumption, Saving and Investment:

Changes in the real interest rates affect the demand for consumption andsavings of the people and also change the investment pattern of the businesses.For instance, a reduction in real interest rate lowers the cost of borrowing,encouraging people to borrow in order to consume (durable items like, electronic

items, automobiles etc.). Moreover stimulating banks willingness to lend moreand investors to invest more, on the other side discourage saving, resulting toincrease spending and aggregate demand.

Lower real interest rates also make stocks and other such investments moredesirable than bonds, resulting stock prices to rise. People are likely to increasetheir stock of wealth.


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Foreign Exchange, Imports and Exports:

Short-run changes lower interest rate result as currency depreciation, whichmeans lower prices of home-produced goods selling abroad, making exportsdearer and discourage imports, reducing the gap between imports and exports

and having favorable balance of trade. Again this leads to higher aggregatespending on goods and services produced in the country.

Output and Employment:

The increase in aggregate demand for the output boosts up the production cycle;generating employment, as a result increase investment spending on the existingindustrial capacity. Which accelerate the consumption further due to moreincomes earned, thus attaining the multiplier effect of Keynes.

How does Monetary Policy affect Inflation?

Monetary policy affects inflation in two ways. First, affecting indirectly, if monetarypolicy able to achieve multiplier effect, it boosts up economic activity. Initiatinglabor and capital markets to raise outputs beyond there capacities and creatingan upward pressure on wages, thus resulting inflation to rise (that is cost-pushinflation). Thus there would be a trade-off between higher inflation and lowerunemployment in the short-run which further accelerate inflation. As wages andprices start to rise they are hard to bring down back, stressing the need for earlypolicy measures to be taken. Secondly, monetary policy can directly affectinflation via future expectations. Like if people expect the rise in prices in future,they persuade to increase in wages, which in turn affect the prices, resultinghigher-inflation.

Limitations of Monetary Policy:

Changes in money supply are governed by three factors, viz., (a) the domesticprivate sector, (b) the government sector, and (c) the foreign sector. Theinfluence of the private sector on money supply is reflected in loans to the privatesector by banks and their investment in private securities. An increase in thevolume of bank credit to the private sector or the banks' investment in privatesecurities tends to increase money supply.

The influence of the government sector on money supply is reflected in the loans

from the State Bank and commercial banks to the government sector and theirinvestments in government securities adjusted for the change in their cashbalances with the State Bank. An increase in such credits and investments hasthe effect of directly increasing money supply and vice versa. As regards thecash balances of the central and provincial governments, a decline in their levelincreases money supply and vice versa/The counterpart funds, which representthe sale proceeds of commodities received under aid arrangements in Pakistan,also have an impact on the level of money supply. The commodities received as


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aid are sold in the country and the money so realized is credited in a specialaccount in the State Bank from which releases are made to the governmentprimarily for financing development project. If the level of counterpart fundsincreases, reflecting an excess of accumulations over releases, it exercises acontractionary effect on money supply and vice versa.

The third causative factor is the foreign sector, which includes the State Bank'sholdings of gold and foreign assets and authorized dealers' balances. Wheneverforeign exchange receipts exceed payments, and the level of foreign exchangereserves rises, there is a net addition to money supply. Conversely, whenpayments exceed receipts, and the foreign exchange reserves decline,It has a contractionary influence on money supply. This analysis of changes inthe money supply shows that money supply in circulation and deposit money, arenot regulated by the State Bank alone. The monetary assets vary in accordancewith the causative factors. There are three broad ways of controlling the level ofmoney supply. It can be reduced through (a) running down of foreign exchange

reserves, (b) restriction of credit to the private sector, and (c) restriction of creditto the government sector. Similarly, if the objective is to step up the rate ofmonetary expansion, (a) building up foreign exchange reserves (b) expandingcredit to the private sector, and (c) expanding credit to the government sectorcan attain it.

Limitations on the effectiveness of monetary policy are thus of two types. Theymay arise because-as the Keynesians show--the elasticities are not right. Thedemand for real money is interest elastic and investment demand is interestinelastic so that an increase in money supply does not significantly enhanceaggregate demand.Alternatively, monetary policy may be ineffective because of the powerlessnessof the State Bank vis--vis (a) the domestic financiers (b) the government and (c)international money markets. Kaldor has argued forcefully that the central bank ismerely an instrument of capitalist policy. It has no choice but to passivelyaccommodate the preferences of profit maximizing private banks and to continueto act as the' lender of the last resort. World Bank literature bemoans theimpotence of the central bank, vis--vis national government and rising levels ofbank borrowings to finance the budget deficit.

World Bank literature insists on the need to increase the autonomy of the StateBank but since this recommendation is seen as being one element in a push formacroeconomic liberalization, the autonomy the State Bank gains from thegovernment is soon lost to the international money market. Liberalizationenvisages both current and capital account convertibility. This undermines theability of the State Bank to control the movement of external reserves. It merelyaccommodates the domestic monetary system to the rhythm of the internationalmoney markets. Domestic interest rate structures and credit allocations reflect


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the policy preferences of global capitalists. The growing impotence of the StateBank calumniates in its conversion into an imperialist currency board.

Conclusion:

The results show that mostly developing countries fail to attain the desired goalsof monetary policy. The basic hurdles are the deep debt burdens on government,and inflation pressures. Like, Pakistan, although adopted tight monetary policy,stood at actual inflation rate of 7.7% (FY 2006-07), against the inflation target of6.5% (in FY 07). However, the monetary policy plays effective role to control themoney supply in economy in the short-run for a sustainable prosperous long-termgrowth of developed countries.

3.2 Monetary Policy Department of SBP

Monetary Policy Department (MPD), one of the core departments of the StateBank, is responsible to provide candid feedback for monetary and exchange ratemanagement and facilitates the Monetary Policy Committee (MPC) in monetarypolicy formulation and decision making process. The Department is primarilyengaged in the following major activities which include::

Preparation of Monetary Policy Statement;

Preparation of dossier/working papers for various Committees; ;

Making projections for future inflation and economic outlook usingMacroeconomic Model and Financial Programming Framework;

Preparation of Monetary Surveys;

Preparation of Annual Credit Plan;

Periodic analysis of monetary and credit developments; Contribution to consultations with the IMF;

Appraisal of world economy and financial developments; and

Empirical research papers.The Department has been divided into the following Divisions:

Monetary Survey Division

The Division is responsible to provide information and objective analysis to themanagement for prudent policy decisions. The Division is also responsible for the

preparation of weekly Monetary Surveys and its allied information; analysis ofmoney & credit trends; identification of issues and concern; assessment of policydevelopments and provision of input to the internal & external stakeholders. TheDivision prepares Annual Credit Plan/working papers for NCCC meetings andserves as the NCCC secretariat. It also contributes in providing information andanalysis to the MPC and the Monetary Policy Statement.

Policy Formulation Division


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The Division provides intellectual, analytical and data support for monetary policyformulation and appraisal, and furnishes working papers and backgroundmaterial for the MPC, Monetary and Fiscal Policies Coordination Board(MFPCB), Economic Coordination Committee (ECC) and Investment Committee

meetings, thereby contributing to the efficient conduct of monetary policy andmacroeconomic management. The Division also contributes in the preparation ofMonetary Policy Statement taking into account global and regional policyinitiatives..

Macro Modeling Division

The Division has been assigned the responsibility to make predictive assessmentregarding inflation and future outlook of the economy. The Division is engaged inthe following prime activities.

To make forecast for major economic indicators and to provide an3independent assessment of the future outlook of the economy, Quarterly,and Annual Reports,

To make forecast for major economic indicators on monthly basis as aninput for policy decisions, and

The quarterly updation of the medium-term forecast (current plus threeyears ahead) based on Financial Programming

3.3 Making Monetary Policy in Pakistan

The recent widespread concern about galloping inflation in Pakistan raises an

important question: who makes monetary policy in Pakistan? Monetary policy isthe responsibility of the State Bank of Pakistans (SBP) Central Board. The boardapproves all measures pertinent to the conduct of monetary policy as it does inother fields within its mandate, such as exchange rate policy.

The composition of the Central Board, a vital institution that touches the lives of160 million people, is obviously important. However, a look at this compositionreveals a disquieting picture. The Central Board of the SBP is comprised of itschairman, the governor, a bureaucrat from the ministry of finance, and sevendirectors, one from each province, nominated by the federal government whorepresent agriculture, banking and industrial sectors.

While there is no doubt that some members of the Central Board are persons ofhigh moral fiber and integrity, the presence of representatives of agriculture,banking and industry poses potential conflict of interest issues. A board memberwith prior knowledge of interest rate and exchange rate decisions, or anydecision that affects his business, can use this confidential information topecuniary benefit. Furthermore, given the special interests they represent, theirviews are probably not unbiased. Nor are these persons likely to be economists,


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monetary specialists, or have a feel for how monetary policy is conducted.

The presence of a bureaucrat on the board would seem to be of little benefitgiven their typically generalist background, unless it is a way of the ministry offinance to keep tabs on what is going on at the central bank. The fact that seven

members of the board are appointed on the recommendation of governmentraises all kinds of doubts on the integrity and objectivity of the recommendationprocess.

What is striking is that there appears to be no professional monetary economistin the Central Board. There is probably no economist at all, and, even if there isone, his views can be set aside by the majority. How the board can grasp thetechnicalities and nuances of conducting monetary policy and make sounddecisions without expert input is beyond comprehension.

Decisions on the stance and implementation of monetary policy, and the crucial

issue of timing of policy actions, is too serious and complicated a business to beleft to self-styled, arm-chair monetarists who work part-time.

3.4 Monetary Policy Transparency (Analysis)

Monetary policy transparency involves the disclosure of information by thecentral bank relevant to the conduct of monetary policy and requires symmetricinformation between the central bank and the private economic agents. Atransparent central bank cannot have superior information about the state of theeconomy, transmission mechanism, economic data, and institutionalarrangements etc. It is important to note that transparency does not requireperfect knowledge of the economy as both the central bank and the generalpublic may have imperfect information regarding shocks to the economy.Complete transparency requires openness on every aspect of the policy makingprocess from objectives/ultimate goals of monetary policy to quantitative targets,relative weights on each of the objectives and the functional form of the objectivefunction, and from setting policy instrument to achieving ultimate goals. Atransparent monetary policy entails several benefits. To begin with, transparencylies at the heart of central bank independence and accountability. Mishkin (2004)and Nijathaworn (2006) argue that transparency increases public support forcentral bank policies, which is essential for winning central bank independence.The increased independence requires accountability of the central bankers to thesociety, as it is necessary for the legitimacy of the monetary policy, [Goodhart,

Hildebrand, Lipton, and Wyplosz (2001); Mishkin (2004); Briault, Haldane, andKing (1997); Buiter (1999); and Geraats (2002b)]. However, accountability of thecentral bankers cannot be achieved if the public is not fully informed of themonetary policy-making process. In this way, transparency can be thought of asa complement to central bank accountability [Geraats (2002a)]. Second,transparency not only helps improve the efficiency of the central bank but alsomakes it costly for the central bank to deviate from societys preferences7 [Buiter(1999); Bernanke, et al. (1999); Blinder, et al. (2001); and Roll, et al. (1993)].


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Third, increased transparency can help reduce uncertainty in financial marketsthereby improving long-run growth prospects [Nijathaworn (2006); Poole, et al.(2002); Svensson (2003)]. Fourth, a high degree of transparency forces thecentral bank to adhere to the stated objective and targets, thus increasing thecredibility of the central bank [Faust and Svensson (2001); Levin, et al. (2004)].

Monetary policy transparency holds particular significance for developingcountries where misperceptions and lack of knowledge about monetary policyissues and outcomes are not uncommon. In this context, an important benefit oftransparency is that it can educate the public about what monetary policy canand can not do and thus avoid unnecessary criticism on the central bankers[Svensson (2002)]. Another benefit of transparency for developing countries isthe promotion of public dialogue on policy issues that can be instrumental inbringing central bank policies in line with societys preferences. Also, atransparent monetary policy is vital for enforcing fiscal discipline on governmentsthat rely heavily on seignorage revenues to meet budgetary shortfalls. Finally,monetary policy transparency can allow the public to compare central bank

performance with international best practices, and thus create public pressure forthe adoption of such practices whenever the performance of the central bankfalls short of internationally accepted benchmarks.

Q. HOW TRANSPARENT IS THE SBP?

Political Transparency

According to Eijffinger and Geraats (2007), political transparency refers to theopenness about monetary policy objectives, quantification of these objectivesand institutional setting for interaction between government and the central bank.

Formal Objectives: Pakistan is a developing country having multiple objectives ofmonetary policy. SBP has the dual mandate of maintaining price stability andpromoting output growth along with other objectives like foreign exchange ratestability. There has been no clear prioritization of the objectives with shiftingpreferences between price stability and output growth. Monetary policy has beenkept expansionary whenever inflation was under control and/or government wasunable to provide fiscal stimulus. This was exactly the strategy in 2006-07. But asinflation reached a sufficiently high level, the SBP tried to contain it (like thecontractionary actions taken in 2008 and are still in force). This behavior is clearfrom the statements given in SBPs monetary policy statements.

Though the SBP clearly states its objectives, it does not provide an explicitstatement on their prioritization. One may argue that prioritization is mentionedwhenever required in monetary policy reports by the SBP and hence it istransparent in this regard. But we should keep in mind the objective oftransparency i.e. less uncertainty about central banks actions. To reduceuncertainty about central bank actions it is necessary to have knowledge oncentral banks long-term objectives and their prioritization in case of multipleobjectives. Though SBPs documents often spell out the intentions and


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preferences of the bank for the near future (mostly for one year), these maychange depending on the state of the economy. Also, theex-post statements bythe central bank are merely policy explanations that cannot be taken asfurthering the objective of transparency. Therefore, one can say that the SBP istransparent on announcing the objectives but not on the issue of prioritizing the

multiple and conflicting objectives. Consequently, it is awarded a half score onthe issue of formal objectives (Figure 1).

Quantification of the Targets: The announcement of targets reduces uncertaintyfaced by the economic agents in making economic decisions. The SBPannounces one-year inflation and output targets but provides no information onmedium term targets. However, the announcement of one-year targets is of littlevalue to economic agents who make decisions on the basis of expectationsabout medium or the long run. Furthermore, as Geraats (2005a) points out, theshort-term targets are just forecasts/projections rather than the targets in theconventional sense, as the lag with which monetary policy actions affect the

outcome (inflation) is normally greater than one year. We, therefore, concludethat the objective of transparency (reducing uncertainty) is not achieved byannouncing just the short-term targets, and hence the monetary policy inPakistan is still deficient in this area justifying a zero score on this count (Figure1).

Institutional Arrangement: The process of independence of SBP effectivelystarted in July 1993. The SBP Act 1956 was amended by a bill passed inFebruary 1994 making monetary policy the sole responsibility of the SBP. TheAct was again amended in May 1997 to further strengthen the autonomy byentrusting the central board to determine and enforce the limits on credit by theSBP to the government. Subsequently, however, SBP autonomy was effectivelycompromised, first, by an ordinance in December 2000 authorizing the federal


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government to direct the SBP to set up funds for specific purposes as well as tointroduce specialized credit schemes and influence the balance sheet of theSBP, and then by delegating the authority to appoint the governor to thepresident. There are at least two other problems that effectively limit theautonomy of the SBP. First, the SBP governor is appointed for a renewable term

of three years, and this makes the central bank vulnerable to political pressures.Second, as is clear from SBP quarterly reports and Monetary Policy Statements,the unexpected borrowing of the government from SBP continues while thedegree of monetisation of the fiscal deficit remains uncertain. These problemsnotwithstanding, it must be acknowledged that the financial sector reforms of the1990s have provided a modicum of autonomy to the SBP. Therefore, SBP isconsidered as partially transparent in terms of institutional arrangements, earninghalf a score (Figure 1).

Economic Transparency

Economic transparency refers to the release of economic information the centralbank uses for monetary policy including the current state of the economy (dataon key variables), policy model that is used for policy analysis and central banksinternal forecasts.

Economic Data: The data on money supply and inflation are available on aquarterly basis. Though GDP is compiled on an annual basis, as is theunemployment rate, some informal analysis in the form of indicators is providedin SBP quarterly reports. Capacity utilization is discussed, on quarterly basis,only for large-scale manufacturing and not for the whole economy. All in all, SBPis partially transparent on data publication and there is stillroom for improvement.Thus a half score is assigned to SBP on this account (Figure 2).

Macroeconomic Model: I could not find any information from formal sources onwhether or not the SBP uses a macroeconomic model. However I obtainedinformal information that SBP now has its own macroeconomic model. The factremains that SBP has never explained how the SBPs internal forecasts aremade and how does it conduct policy analysis. So the monetary policy iscompletely opaque on this issue in Pakistan and hence a 0 score is assigned(Figure 2).


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Central Bank Internal Forecasts: SBP publishes quarterly forecasts both forinflation and output normally at quarterly frequency but there are some problemswith these forecasts. First, these forecasts are available only for the short run (forone year) and not for the medium or the long run. The publication of forecastsreduces uncertainty in the markets and makes the central banks intentions more

transparent only if the forecasts are at least for the medium term. Keeping in viewthe long lags required before the effect of policy instrument on outcomesmaterializes, these forecasts do not make any sense. Second, although the SBPexplains rough indicators of forecasts, it does not provide information on how thequantitative forecasts are made. So forecast mechanism is absent in its reportsas are the assumptions or policy instrument path these forecasts are conditionedon.

Third, SBPs forecasts cannot be called internal forecasts. These are simple andrough projections that any organization can make. Internal forecasts help centralbank analyze how the policy decisions on the instrument path change the

inflation and/or output in the long run. From the societys point of view, internalforecasts are important not only because they give some idea about the futurebut also because they serve as an indication of the central banks intentions.These objectives cannot be achieved if the policy instrument path is missing fromthe process of forecasting. Finally, one of the objectives of transparency aboutforecasts is to raise awareness in the public about the seriousness of the centralbank in achieving the announced objectives. If forecasts based on policy ratepath are not close to the stated objectives then it is an indication of the deviationof central bank policy from that of announced one. In this case, academia andprofessionals outside the central bank may point out this. So the central bankswould not like to involve in a policy setting that cannot produce forecasted resultsaccording to the stated objectives, if the public has information on the forecasts.

The above discussion shows that the forecasts published in SBP reports do notserve as indicators of the central banks seriousness in achieving the objectivesand cannot fulfill the objective of transparency in terms of affecting privatesectors information. Thus monetary policy is not fully transparent in this area ifwe consider the objective of transparency, though it is transparent if we take theshort run forecasts without specification of the assumption about policyinstrument path. So the SBP is awarded half score as it is partially transparent interms of forecasts publication. (Figure 2).

Procedural Transparency

Procedural transparency refers to the information on the way the decisions aremade by the central bank. According to Eijffinger and Geraats (2007), this type oftransparency involves explicitness on monetary policy strategy and minutes andvoting records of monetary policy committees meetings.

Explicit Strategy: Regarding explicitness on the monetary policy strategy inPakistan there is not even a single statement about any type of rule in any of the


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SBPs documents and it seems that monetary policy strategy is characterized bydiscretionary framework. For instance, in 2001 when inflation was well contained,SBP took expansionary stance but changed course to tame inflation in 2005when it was quite high. Thus there is uncertainty about both the degree as wellas the timing of the monetary authoritys leaning against the wind. It is not clear

as to at what level of inflation and/or output gap the SBP will decide to react.Also, there is uncertainty about how much the policy instrument would changewhen there is deviation of output and/or inflation from the target. This is notsurprising as the SBP has never claimed to follow any type of rule. So on thebasis of this discussion it is concluded that SBP has no explicit monetary policyframework justifying a zero score.

Minutes and the Voting Records: There is no tradition of releasing the minutesand the voting records of the policy committees meetings. Only decisions forchanging the policy tools are announced after the policy meetings and nothingmore than that. So the SBP is awarded zero score on both these counts. It is

worth noting here that Procedural Transparency is the only area of monetarypolicy transparency where the SBP is completely opaque.

Policy Transparency

Policy transparency relates to the openness of monetary policy decisions. Itinvolves prompt announcement of policy decisions (probably on the day ofimplementation), an explanation of policy decisions and disclosure of policyinclination or likely future actions.

Prompt Announcement: Policy changes in instruments/tools (open marketoperations, discount (repo) rate etc.) are announced on the day of

implementation. But we must be a bit careful here. The transparency on thisissue involves the information on changes in the operating targets and not just onthe policy tools. It is necessary because unless the public knows the operationaltarget it cannot judge whether the action taken by the central bank is appropriateor not. The impact of policy tools on ultimate targets/objectives is transmittedthrough the formers effects on the operational and the intermediate targets. Sothe SBP is transparent on the inputs (policy tools) but not on the (intermediate)output (operational target). It is important to note that central banks cannot besaid to have private information on the changes in policy tools, as other marketplayers also have the same. To elaborate, suppose there is an open marketoperation, a change in the discount rate or in the reserve requirements; then

commercial banks are involved in this process and thus have perfect informationon these changes. What the commercial banks really do not know is theoperational target of the central bank, for which these tools are being used.

Looking at the SBP practice, it is not clear as to what is its operating target.Although the announced operational target of SBP is reserve money, it is arguedin some studies that the bank instead targets short interest rate since thefinancial sector reforms in early 1990s. Besides uncertainty about this issue, the


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SBP does not announce targets for either reserve money or the short interestrate. However, the policy decisions on targets for monetary aggregate (M2) areannounced in the annual credit plan. It is important to note that the SBP does notprovide information on the short-term changes whereas transparency here isconcerned with policy decisions in every monetary policy committees meeting

and not with the annual targets. Also, the target for M2 is not a target as such,rather it is just a projection that depends on the overall projection of theeconomy. This argument is reinforced by the actions of the SBP in achieving thetarget for M2, as this target has been missed frequently in the history. On thebasis of absence of information on the operational target, SBP has beenawarded zero score.

Policy Explanation: SBP does provide some explanation when there is a policychange. For instance, when there was a change in required reserve ratio by theSBP for commercial banks, it explained the objectives and the likely effects of thepolicy change as well as the rationale for such a change. But it is important to

note that these explanations are for the changes in the policy tools and not forthe changes in the operational target of the SBP. Similarly, although the policychanges are explained, there is no tradition of explaining decisions in everypolicy committees meeting. Another point that needs to be discussed is thattransparency requires explanation just after the committees meeting and notafter a substantial lag, which is the practice in Pakistan. For instance theexplanation of policy change (stated above) was published six months after thepolicy decisions. Though still desirable, it is far from achieving the objectives oftransparency.

In conclusion, the SBP is partially transparent in this respect and on the basis ofthe above discussion, SBP is awarded half score (shown in Figure

3) as it does

not explain all decisions after every policy committees meeting and providesexplanation only after a substantial time lag.


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Policy Inclination: SBP does some forward-looking analysis in its quarterlyreports as well as in six- monthly monetary policy statements (MPS). Theinformation in these reports provides some indication about the future stance ofthe monetary policy. However, a somewhat deeper analysis is required to assesswhether or not the SBP is transparent on this issue. There are three points that

need to be discussed in this regard. First, the SBP does not publish projection ofthe future policy rate. Second, from most of the SBP reports, the message onfuture policy actions is not very clear. Occasionally in its reports, the SBP signalspolicy tightening while at the same time indicating possible actions for the outputgrowth and vice versa. Third, although the SBP reports do contain some forwardlooking analysis but it is not done after every policy meeting, which is anessential requirement of transparency on this issue. On the basis of this analysiswe can say that SBP does not clearly indicate future policy instrument path andhence is not transparent in this respect (zero score) as indicated in Figure 3.

Operational Transparency

Operational transparency is concerned with the role of monetary policy inachieving targets set by the government. Not all of the variables are in perfectcontrol of monetary authority so there are chances of deviations from the targets.There are essentially three elements in this type of transparency: deviation fromoperational target (control errors), contribution of monetary policy in achievingfinal objectives, and unanticipated disturbances that may affect the transmissionmechanism.

Control Errors: State Bank of Pakistan, in all its reports, regularly announcestarget for monetary aggregate (M2) and also discusses past deviations andreasons for these deviations. Even in its quarterly reports, it carries out someforecast analysis to assess the likelihood of getting monetary aggregate ontarget. Though the SBP publishes deviations from the targeted monetary growth,it does not provide this kind of information on operating targets. However, wethink that by this practice transparency is not affected because of the followingtwo reasons. First, factors that make monetary aggregate deviate from the targetare almost the same that cause deviation in operational target. Second, thequestion on this issue does not require a time frequency that is greater than oneyear. So although operational target is needed to be announced and explainedmore frequently, the question of why the target was missed can be analyzed atannual frequency. According to the options given in Eijffinger and Geraats (2007)question 5(a), SBP is transparent, getting full score on giving explanation for

missing the target as shown in Figure 4.

Transmission Disturbances: The State Bank of Pakistan provides information onthe shocks only superficially without a deeper analysis. In particular, the SBPexplains deviations from the target (for inflation and output) but not the forecasterrors. However, as targets for one year are just the projections, explaining thedeviations from the target implicitly provides information on forecast errors. In thissense, the SBP explains past forecast errors in its documents, e.g. Monetary


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Policy Statement of Jul-Dec 2006, gives some idea of explanation by SBP onwhy inflation target (projection) for the fiscal year 2005 was missed. However, asinformation provided is only indirect, the SBP is awarded half score on this issueas shown in Figure 4.

Policy Evaluation: Although the State Bank of Pakistan does not provideinformation on the exact contribution of monetary policy in achieving theobjectives, it conducts some superficial analysis of policy evaluation. Howeverone can infer from the analyses in the reports that whether or not the policy issuccessful in achieving stated objectives. There are certain statements in SBPreports showing the relationship between macroeconomic outcomes andmonetary policy stance, though the exact contribution of monetary policy inachieving the targets is never mentioned. For instance, in Monetary PolicyStatements of the last year, the SBP attempted to communicate that monetarytightening by the bank had contributed to lower inflation. So we have concludedfrom the statements in SBP reports that monetary policy in Pakistan is partially

transparent on policy evaluation according to Eijffinger and Geraats (2007)definition and options in the questionnaire. As Figure 4 shows, SBP has beenawarded half score on policy evaluation.

In summary, the SBP has been awarded an aggregate score of 4.5 out of 15.This is lower than any of the central banks score in Eijffinger and Geraats

(2007). The most deficient area is the procedural transparency where SBP hasscored zero because neither the monetary policy strategy is explicit nor is there atradition of releasing voting records and minutes of the monetary policycommittees meetings. Another area where deficiency is prominent is the policytransparency, where the major deficiency is in the announcement and the clarityof policy operational target and in indicating future policy actions. In political andeconomic matters there is partial transparency and the major deficiency is inpublishing medium term forecasts and in making policy model explicit.


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Operational transparency is the only area where there is a moderate level oftransparency. Here the performance is better mainly because of providinginformation on control errors, though there is also partial transparency ontransmission disturbances and policy evaluation. It is worth stating that 2 out of4.5 (total score on transparency in Pakistan) is contributed by operational

transparency. Figure 5 shows aggregate score of the SBP.

3.5 Transparency of SBP In Comparison With the Other Central Banks

It is instructive to compare the transparency index for State Bank of Pakistan withcentral banks studied in Eijffinger and Geraats (2007). The comparison mainlyfocuses on the practices of only those central banks that either got maximum

score in an area or their score is very close to that of SBP. Overall, SBP hasscored 4.5 (out of 15) and lies at the bottom in comparison with these ninecentral banks. In Eijffinger and Geraats (2007), the maximum score (14 out of 15)is awarded to the Reserve Bank of New Zealand and Riks bank while the SwissNational Bank got only 7.5 score, the lowest in their sample. The main deficiencyof SBP is in procedural transparency where it achieved zero score. Bank ofEngland, Riks bank and Reserve Bank of New Zealand are fully transparent inthis regard but most of the central banks are less transparent on this issue, e.g.Swiss National Bank, Reserve Bank of Australia, Bank of Canada and EuropeanCentral Bank (ECB) got only 1 (out of 3) score on procedural transparency.These central banks are less transparent due to almost the same reason: opacity

in providing minutes and voting records of monetary policy committees meetings .


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Another area where deficiency of the SBP is more prominent is policytransparency (0.5 score out of 3). Central banks with full score on policytransparency are Federal Reserve, Riks bank and Reserve Bank of NewZealand. The main reason for SBP being at the bottom is opacity in theannouncement of operational target. It is interesting to note that none of thecentral banks in Eijffinger and Geraats (2007) is opaque on this issue. ReserveBank of Australia, Bank of England and Bank of Japan are least transparent inpolicy matters as they scored only 1.5 (out of 3). The reason for their deficiencyis opacity on policy inclination.

Most of the central banks in Eijffinger and Geraats (2007) got full score onpolitical transparency. Interestingly, SBP and Federal Reserve are equallytransparent (scoring 1 out of 3) in this respect. Not only this, their reason fordeficiency is also the same: both are opaque on quantification of the targets.Bank of Japan that has also low score (1.5 out of 3) has similar reason fordeficiency. SBP got the same score (1 out of 3) on economic transparency. Onlytwo central banks, Bank of England and Reserve Bank of New Zealand are fullytransparent on this front. On the lower side is the Swiss National Bank with score1.5. Reason for lower score-opacity regarding policy modelis same for SBPand Swiss National Bank. The only area where SBP has shown significantimprovement is operational transparency. Interestin

Role of State Bank Monetar Policy

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