This paper deals with the computation and analysis of some fundamental reserve aggregates and associated monetary statistics, which impart important information regarding the design and conduct of monetary policy at the State Bank of Pakistan (SBP). Specifically, we compute the data series for borrowed, unborrowed, free, and drainable reserves using balance sheet data published by the SBP for the period 1985-2009. Results show that Pakistan's monetary policy revolves around managing the exchange rate while using the t-bill rate as a key policy instrument. However, the value of the t-bill rate is both incorrectly and sub-optimally related to macroeconomic fundamentals rendering monetary policy time inconsistent. This hinges on the finding that, since 2000/01, the SBP has targeted the net free reserves of the banking system at 4 percent of total private deposits. Among other observations, we find that the scope of open market operations as a tool of monetary policy remains limited and that this limited role of open market defenses derives from the concern of the central bank to sterilize its own foreign exchange reserves. Furthermore, the growth rate of unborrowed plus drainable reserves bears a strong negative correlation with the annual average rate of inflation, which, on account of the former being consistently negative since 2005, implies that neither the government nor the SBP have an overriding concern for controlling inflation.
Keywords: Monetary policy, central banks, Taylor rule, monetary targets, Pakistan.
JEL Classification: E51, E52, E58.
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This paper deals with the computation, presentation, and analysis of some fundamental reserve aggregates and associated monetary statistics for Pakistan that the State Bank of Pakistan (SBP) does not explicitly publish (or even make any reference to in policy discussions) but which, nevertheless, impart important information regarding the design and conduct of monetary policy at the SBP.
Our analysis originates in the fundamental question as to what drives monetary policy at the SBP. The SBP describes its policy as a set of discretionary measures that are implemented as and when deemed necessary, and which derive from a detailed review of the state of the economy, the practices of the banking system, and the statement of objectives of monetary policy (see, for example, SBP, 2009a, 2009b). In contrast to the claims of the SBP, we find that changes in the t-bill rate are systematically related to the rate of growth of national output, the rate of inflation, and the currency depreciation rate (Hassan & Shahzad, 2010).1 This implies that the SBP implicitly subscribes to a Taylor type rule (see Taylor, 1993, 1998) which, quite unusually, dictates that it (i) raise the t-bill rate when output growth declines (Malik and Ahmad, 2007, also observe the same), and (ii) raise the t-bill rate when inflation increases (only in the long run) but by less than the amount of increase in inflation. This situation is further complicated by the SBFs claim that changes in the t-bill rate do not necessarily reflect changes in monetary policy and that the key monetary policy instrument at the SBP is the discount rate (SBP, 2009b).
The design and conduct of monetary policy- apart from the standard procedure of determining objectives, setting quantitative targets, choosing instruments, and ascertaining the way changes in instruments will help attain these objectives- requires the central bank to choose an operational target of monetary policy. This operational target is "an economic variable, which the central bank wants to control, and indeed can control, to a very large extent on a day-by-day basis through the use of its monetary policy instruments" (Bindseil, 2004). The SBP has never explicitly stated its operational target in any of its publications except for the recent monetary policy statement (SBP, 2009b) which states that the SBP targets the rate of monetary expansion consistent with (i) estimates of net foreign assets, (ii) estimates of the government's budgetary borrowing, and (iii) aggregate demand pressure reflected in the saving-investment gap. …