The banks are not too big to fail, the government is

The State Bank of Pakistan seems to have given up considering the finance ministry a rational government body that has made some otherwise inadvisable decisions. It is now almost openly talking about the ministry as one would about a relative with a substance abuse problem.

In keeping with the central bank’s tradition of subversive competence, this little nugget of an exasperated rebuke is buried deep in the middle of an SBP report on the state of the economy during the third quarter of fiscal year 2013. It seems to have been placed, almost on purpose, in a place where hardly anyone would find it: in a section titled “Macroeconomic dynamics with a dominant borrower (government)”.

The section relies on unpublished research conducted by the SBP’s Chief Economic Adviser Mushtaq Khan. It talks about what the State Bank’s options are, considering the finance ministry’s refusal to respond to any of the SBP’s policy measures (though it saves the good stuff for the footnotes, no doubt hoping that nobody in the finance ministry would notice and stop them from being published). It also appears to comprehensively address many of the criticisms that are levelled at the central bank for not doing much to control the behaviour of the finance ministry.


The most often-used criticism is that the central bank should be raising interest rates – not lowering them – to force the government to stop borrowing so much. The report responds to that suggestion by saying: “Price signals often fail in structurally distorted economies. A desperate borrower does not respond to price signals; this is especially the case with addictive goods/services. While increasing interest rates is sufficient to deter an individual from borrowing more, in the case of a government with a short-term horizon, the rising cost of credit will not deter fresh borrowing, but only increase the government’s indebtedness and squeeze the fiscal accounts further.”

In case you missed that, the State Bank is quite frankly talking about the finance ministry as if it were a drug addict. Well, what about treating this addict by taking away their drugs; in this case, as some people suggest, by absolutely refusing to lend to the government or bouncing their checks that go beyond a certain limit?

The SBP once again has a very forthright answer to that (again in the footnotes): “We dismiss the suggestion that an independent central bank can, and should, impose a hard ceiling on government borrowing to be implemented by bouncing federal government cheques if required. In our view, no central bank may want to take such a course of action, as this would not only seize up the money and currency markets, but could easily trigger a full-blown banking crisis.”

In effect, the finance ministry is an addict that the State Bank has tried to send to rehab several times, but the only thing they seem to be getting is a series of relapses. So, at this point, the SBP is less concerned about the government’s finance health and more concerned with trying to contain the damage to the rest of the economy.

In 2011, the public sector overtook the private sector as the dominant borrower, accounting for a majority of loans outstanding the country’s commercial banking system, which accounts for the overwhelming bulk of the country’s financial system. Ironically, the more the government’s borrowing crowds out investment and slows down economic growth, the more risk-averse banks become and the more they are inclined to lend even more to the government – a vicious cycle that the SBP appears to admit it has no way of breaking.

The SBP’s econometric models suggest that raising interest rates would only further increase the likelihood of an economic crisis, and that the central bank’s best bet of averting – or at least delaying – disaster is to lower interest rates. Nonetheless, this is not a sustainable solution, and the State Bank admits as much. The report, however, is disturbingly short on ideas about how this ends.

Published in The Express Tribune, June 16th, 2013

Farooq Tirmizi

CEO, Elphinstone

Farooq Tirmizi is the founder and CEO of Elphinstone, the financial services firm that operates SmartRupee.

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