1/ A long thread on how to think about central banking in developing countries like Pakistan.
For central banks (CB) to be effective, they must first work on establishing two pre-conditions.
For central banks (CB) to be effective, they must first work on establishing two pre-conditions.
2/
(i) flexible exchange rate (ER) management
(ii) macro-prudential and capital control regulation
(i) flexible exchange rate (ER) management
(ii) macro-prudential and capital control regulation
3/ Read the leading scholar, @helene_rey , for the full conceptual argument.
bit.ly/2G329Gu
Here's the short version:
(i) ER should reflect market reality, e.g. if productivity growth is lower than competing countries, ER has to depreciate.
bit.ly/2G329Gu
Here's the short version:
(i) ER should reflect market reality, e.g. if productivity growth is lower than competing countries, ER has to depreciate.
4/
(ii) Benefits of free global capital flows have proven to be elusive or illusive. Unregulated capital inflow can build dangerous external liabilities that whiplash the economy & severely constrain the CB.
East Asia learned it the hard way in 1998, Mexico before that etc.
(ii) Benefits of free global capital flows have proven to be elusive or illusive. Unregulated capital inflow can build dangerous external liabilities that whiplash the economy & severely constrain the CB.
East Asia learned it the hard way in 1998, Mexico before that etc.
5/ Pakistan's economy has suffered massively in the past because its state bank ignored these pre-conditions for sound central banking. Some examples.
In early 90s local $ deposits were allowed, with proceeds funding current account deficit, leading to the severe crisis of '98
In early 90s local $ deposits were allowed, with proceeds funding current account deficit, leading to the severe crisis of '98
6/ Successive governments have relied on external borrowing for short-term economic boost, leading to repeated IMF programs.
Mr. Dar under PMLN believed in mythical ER theories, and kept an appreciated ER that devastated exports and lead to a very painful adjustment period.
Mr. Dar under PMLN believed in mythical ER theories, and kept an appreciated ER that devastated exports and lead to a very painful adjustment period.
7/ The consequences of poor central banking have been harsh:
With little confidence that Pakistan will be insulated from external whiplashes, long-term investment does not happen. For example, Pakistan's debt has the lowest maturity among its peers.
With little confidence that Pakistan will be insulated from external whiplashes, long-term investment does not happen. For example, Pakistan's debt has the lowest maturity among its peers.
8/ The repeated boom-bust cycles raise the risk-premium leading to high cost of funding for businesses.
The country loses sovereignty due to external fragility, finding it harder to run an independent foreign policy as exemplified by multiple recent events.
one can go on ...
The country loses sovereignty due to external fragility, finding it harder to run an independent foreign policy as exemplified by multiple recent events.
one can go on ...
9/ So what should be done?
The state bank needs to formulate and communicate a macro-prudential and external capital regulation policy based on the following principles:
The state bank needs to formulate and communicate a macro-prudential and external capital regulation policy based on the following principles:
10/
(i) Flexible ER management to deliver accumulation of real net reserves, essentially modest current account surplus, for a while. This would also send a strong signal of support to the export sector.
(i) Flexible ER management to deliver accumulation of real net reserves, essentially modest current account surplus, for a while. This would also send a strong signal of support to the export sector.
11/
(ii) Discourage short term debt and portfolio flows. Promote long-term capital formation via FDI, but with proper valuation protocols and technology transfer.
(iii) Strong safeguards against money-laundering and capital flight.
(ii) Discourage short term debt and portfolio flows. Promote long-term capital formation via FDI, but with proper valuation protocols and technology transfer.
(iii) Strong safeguards against money-laundering and capital flight.
12/
(iv) Capital account convertibility should be prioritized for tradable & high-spillover sectors, and for long-term capital. Convertibility should be discouraged for non-tradable sectors such as real estate.
(iv) Capital account convertibility should be prioritized for tradable & high-spillover sectors, and for long-term capital. Convertibility should be discouraged for non-tradable sectors such as real estate.
13/ We have not seen a coherent framework that takes these principles into account.
In fact, on the worrying side, the government has gone out of the way to encourage short-term foreign investment in government Tbills.
dawn.com/news/1528985/f…
In fact, on the worrying side, the government has gone out of the way to encourage short-term foreign investment in government Tbills.
dawn.com/news/1528985/f…
14/ There is little benefit of such inflows in the case of Pakistan, and much potential risk. As already explained, if these short-term liabilities continue to build, they can constrain monetary policy and generate external vulnerability.
