In his 2011 article, Dr Muhammad Yaqub, the former governor of the State Bank of Pakistan (SBP), emphasised the need for controlling money supply to maintain its soundness.

HPRIME’s report on Sound Money, which evaluates Pakistan’s monetary stability and analyses macroeconomic policies that have shaped its current state, echoes the same.

Pakistan’s economy is struggling with low growth due to a lack of necessary prerequisites for economic prosperity. The path towards prosperity is determined by the functioning of markets, which requires economic freedom for its agents.

Economic freedom is defined as the degree to which individuals’ property rights are respected in society. Money is a property held by almost all individuals, as market transactions now take place in exchange for money.

To ensure property rights over money, macroeconomic policies must maintain its soundness. In the modern world, a country’s money is sound if its value remains stable against domestic and foreign goods, services, real and other financial assets.

The Fraser Institute of Canada uses the Economic Freedom Index to evaluate and rank countries based on their economic freedom. The index consists of five categories, including sound money.

According to the latest annual report, Pakistan ranks 123rd out of 165 countries with a score of 5.98/10. Unfortunately, Pakistan’s rank for sound money is even worse, standing at 150th out of 165 countries with a score of 6.37/10.

Pakistan has maintained an average score of 6.22 for sound money from 2001 to 2023, with the highest score of 6.83 observed in 2002 and the lowest score of 4.60 in 2023.

From 1974 to 2023, the purchasing power of money for the goods and services included in the Consumer Price Index (CPI) basket decreased by a factor of 68. Similarly, the value of one US dollar went up from less than Rs10 in 1974 to Rs248 in 2023, leading to a 25-fold loss in the rupee value.

This monetary fragility can be attributed to excessive monetary growth, where broad money (M2) has grown significantly faster than the real and nominal gross domestic product (GDP).

Over the past 50 years, the real GDP increased by 10 times and the nominal GDP increased by 644 times, while money supply expanded by over 1,000 times.

The report reveals that the government is mainly responsible for the unsoundness of money due to the inefficient mix of monetary, fiscal, and exchange rate policies. Specifically, the rate of monetary expansion has been out of sync with economic fundamentals.

Pakistani government has historically relied heavily on borrowing from the SBP to finance its budget, leading to an unsustainable monetary expansion. Although the amended SBP Act has limited the government’s ability to issue debt to the central bank, monetary expansion has continued.

The SBP has attempted to control inflation and currency depreciation through a reactionary approach, using interest rate as its policy instrument. However, this approach has been unsuccessful, as keeping market interest rates close to the SBP policy rate makes it difficult to control money supply.

If the government, the lead borrower in the market, does not reduce its demand for funds in response to interest rate hikes, achieving the interest rate target becomes challenging. The SBP has to provide necessary liquidity to the market to achieve short-term interest rate targets, making it impossible to control monetary expansion.

The government’s fiscal branch is often held responsible for monetary expansion, resulting from increased spending without the matching revenue. While this argument holds, the federal government is currently caught in a cycle of debt accumulation.

The seventh NFC Award increased the share of provinces compared to the federation, which may be desirable but has made the federal government vulnerable to shocks. The delay in implementing reforms to reduce the size of the federal government in accordance with the 18th Constitutional Amendment exacerbated the problem.

After paying the provinces their due share, the federal government is left with limited resources that are hardly sufficient to service its debt. Debt servicing being charged expenditure is paid first, leaving the government with no room to provide public goods.

Moreover, the government has to borrow more to service its debt when the SBP raises interest rates to control inflation. This borrowing strains the market for loanable funds, prompting the SBP to inject liquidity. Hence, the money supply expands despite the government being barred from directly borrowing from the SBP.

A comprehensive reform agenda is required to improve Pakistan’s money stability. This includes reducing the size of the government, coordinating fiscal and monetary policies more effectively, managing debt efficiently, and creating an environment that promotes sustained and inclusive economic growth.

Reviewing the current monetary-fiscal policy mix and determining an appropriate operating instrument for the State Bank to limit monetary expansion and maintain its autonomy is crucial.

The practice of expanding money supply in response to government borrowing from scheduled banks while setting the policy rate to contain inflation is not productive.

The government has to comply with the Fiscal Responsibility and Debt Limitation Act, and an accountability mechanism should be in place for non-compliance..

Dr Ali Salman is the Executive Director of PRIME and Dr Wasim Shahid Malik is a PRIME fellow. He is the author of the report “Pakistan Economic Freedom Audit: Sound Money as a Case Study”

The article was originally published in "The Express Tribune" on April 15, 2024.