Wednesday, 3 June 2015

The Developmental Role of the Central Bank

by Asad Sayeed

Photo credit: insignificantnobody/flickr

‘States vs. Markets’ was the buzzword for many of us studying economics or politics in the 1980s and 1990s. As the wall collapsed in Berlin – signaling the end of the cold war – the (false) triumphalism of markets was trumpeted. In time, the academic debate also shifted from this simple binary to give way to more heterodox ways of framing issues relevant to policy and social change.

The 2008 global financial crisis, however, brought issues pertaining to the role of the state in managing economic issues back in vogue. Since this crisis, mainly affected developed countries, there has been particular emphasis on central banks in the US and the EU region as this public institution is deemed to have failed home owners through lax regulation on housing finance. Subsequently, the single minded obsession of the European Central Bank on monetary policy has brought into sharp focus the anti-poor bias this policy has resulted in, particularly in Southern Europe.[1] [2]

While not suffering from the same affliction that pro market reforms brought about in the developed world – for we have our own structural bottlenecks to overcome – the debate reminds us of the degree to which the developing world in general and Pakistan in particular trusts the market to allocate resources for development. A case in point is the developmental role of the State Bank of Pakistan (SBP).

The State Bank Act 1956 mandates the Central Bank “to regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with a view to securing monetary stability and fuller utilization of the country’s productive resources.” For the first four decades, this mandate was interpreted by the SBP to intervene in the market through several instruments – priority sector lending for agriculture, key industries, promotion of exports and housing. The SBP also promoted long term finance through Development Finance Institutions (DFIs).

As part of liberalization reforms in 1991, the SBP also abandoned part of its interventionist role. The most salient amongst them was abolishing the DFIs and removing dedicated credit provision to agriculture through the banking sector. Instead, the SBP was to focus on its stabilization functions of regulating the financial sector, the conduct of monetary policy (based on inflation targeting) and exchange rate management.

In (neo-liberal) theory, liberalization was supposed to improve the savings rate by increasing competition; by abolishing directed and priority credit allocations financial intermediation would improve, which in turn will improve productivity by allocating investible resources efficiently and contribute to growth.

In the two and a half decades since liberalization of the financial sector there is a broad range of financial instruments available to the public. These range from micro finance banks, to a whole host of commercial banks, Islamic financial institutions, leasing companies, mutual funds, a range of insurance instruments, investment banks and one of the best performing stock markets in the developing world.

However, in a recent ILO Employment Working Paper, ‘The role of Central Banks in supporting economic growth and creation of productive employment: The case of Pakistan’, we show there is little evidence that the savings rate has gone up or that the investment-GDP ratio has improved or indeed there are indications of investible resources being channeled to high productivity sectors. The case of Pakistan, in fact, demonstrates that liberalization has not resulted in either enhancing the investible surplus in the economy (through savings) nor has it resulted in more efficient intermediation.

The most salient market failure that has occurred since the DFIs were abolished is that most of the financial sector has become geared to short term financing and a very small proportion is available for long term financing. At a time where there is severe dearth of financing for long gestation infrastructural projects, mainly in the energy sector, the gap created by abolishing the DFIs has not been filled.

Moreover, if one goes by the mandate of the State Bank to promote the ‘national interest,’ it can also be interpreted to mean that the SBP should also contribute in removing regional disparities in Pakistan. Figure 1 provides a ratio of lending to deposits between 2001 and 2013 for different regions in the country. This goes to show that lending in Balochistan and KP is not only low but declining over the period. In fact, if we separate Karachi from Sindh, the picture will look more like KP and Balochistan. Although three of the four provinces have their own banks, they are not regulated to operate within their own provinces.

Source: Reproduced from ‘The role of Central Banks in supporting economic growth and creation of productive employment: The case of Pakistan’ by Asad Sayeed and Zubair Faisal Abbasi, I.L.O. May 2015.  Authors' calculations based on data obtained from

So, if one is to imagine that the SBP is to regain its developmental role abandoned two and a half decades ago, what route should it take. Should the state, for instance, create new DFIs? Tempting as it may sound, one has to acknowledge that state failure is an all pervasive reality in Pakistan also. It is still prudent to avoid the ‘market-state’ binary and stick to heterodox approaches in matters of policy reform. It is best, therefore, that the SBP should build on its regulatory strengths if it is to recapture its developmental mandate. This, in turn, is a policy issue that needs to be raised by the elected representatives. Ultimately it is the political leadership that is accountable to people and not the unelected central banks.

[1] Asad Sayeed and Zubair Faisal Abbasi, The role of Central Banks in supporting economic growth and creation of productive employment: The case of Pakistan. I.L.O. May 2015.
[2] Frances Coppola, The Myth of the Omnipotent Central Bank, Pragmatic Capitalism.