In an article that appeared in this newspaper on July 10 (‘The IMF whitewash’) it was pointed out that there was a contradiction about the growth rate for FY14 mentioned in the budget speech of the finance minister and the letter of intent sent to the IMF. Unfortunately, the SBP published its Third Quarterly Report on the same day proclaiming that “the revival of economic activity is a key development in FY14, with real GDP growth of 4.1 percent, which is the highest in the past five years”.

The SBP report was approved by its board of directors chaired by the governor who also had signed the letter of intent sent to the IMF stating that “we now expect that GDP will expand by 3.3 percent in FY2013/14.” The governor needs to explain not only this contradiction in two documents signed by him but his professional conduct as well.

The report gives details of the amount of foreign exchange received in recent months. The combined amount received by the government from all sources aggregated to over $7 billion or about Rs700 billion. Instead of explaining the temporary impact of this large inflow on various sectors of the economy, the SBP has made an attempt to explain developments in all those areas in terms of government policies.

It would be counterproductive to expose the erroneous correlations established by the SBP between statistical developments and economic policies. Instead, an attempt is made to explain how percolation of the foreign inflows in the economy impacted macroeconomic indicators to drive home the message that those trends did not represent the impact of policies but rather the impact of foreign inflows. Foreign inflows can broadly be divided in three categories – foreign grants, foreign exchange receipts from the sale of national assets and foreign borrowing by the government.

As soon as a foreign grant is received, it is ‘bought’ by the SBP and foreign exchange is added to its reserve assets. At the same time, the rupee counterpart of the grant is deposited in the government account with the SBP. The first impact is that the reserves of the SBP go up. The second that the net government bank borrowing goes down. Third, as the government treats the rupee counterpart of grants as its revenue above the line, the budget deficit of the government declines by the same amount.

Fourth, the government’s domestic financing needs decline on the assumption that its expenditure is exogenously determined in the budget document and does not change with the arrival of the grant. Correspondingly, government borrowing from the banking system declines by the same amount.

With the reduction in government bank borrowing the net domestic assets of the banking system go down. To the extent foreign inflows are used to build up foreign exchange reserves, and not to finance the current account deficit or repay an old foreign debt, the decline in the net domestic assets is partly offset by a rise in net foreign assets. But the net impact is a slowdown in the rate of monetary expansion.

In this chain reaction, the balance of payments deficit is readily financed, the foreign exchange reserves are built up, the pressure on the nominal exchange rate stands reduced, the budget deficit is lowered, government borrowing from the banking system declines, there is some reduction in the rate of growth of money supply and with a time-lag price pressures may ease if other factors affecting prices remain the same. Remember all these developments have nothing to do with economic policies and are all driven by a large foreign grant received by the government.

Take the case of sale proceeds of privatisation to foreigners. Its impact will be similar to foreign grants except in one important way. If the national assets were profitable, their sale to foreigners would generate a regular outflow of foreign exchange in the form of transfer of profits abroad each year. If the bulk of the existing profitable assets are sold to foreigners, profit remittance could become a major factor for increasing the deficit in the current account of the balance of payments in future. But that is an impact that is not there at the time the privatisation proceeds are received in foreign exchange.

As for the impact of foreign borrowing, the initial entries will be the same as of grants/ sale proceeds of privatisation. The SBP reserves will go up accompanied by a corresponding increase in government deposits with the SBP and a fall in the net domestic assets.

But since it is a loan, its rupee counterpart will not be shown in revenue above the line and therefore budget deficit will remain unaffected. The rupee proceeds will be shown as foreign financing below the line in the budget with the deficit remaining the same. The impact on money supply and credit availability to the private sector will be the same as that of grants.

There is a major adverse implication of foreign loans as compared with a foreign grant. The volume of foreign debt of the country will go up and so will the foreign debt servicing liabilities of the government. Foreign debt servicing would increase faster in rupee terms if the exchange rate depreciates. There is a limit up to which the budget and the balance of payments can endure the burden of external debt and it would depend largely on export growth and increase in government tax revenue. In the years to come, both the budget and the balance of payments will come under stress due to external debt servicing; moreover, the country will have to repay the debt on maturity.

While the above analysis is a bit technical, its basic understanding is important to establish the link between macroeconomic indicators and macroeconomic policies, and to guard against misleading interpretations presented by official circles.

Let us now revert back to the opening statement in the SBP report: “Pakistan’s economy appears to have turned a corner during the third quarter of FY14. After many years of low growth, sentiments about the economy seem to have improved. Manifestations can be seen in the rebound in real growth rate; the rise in private sector credit; a contained fiscal deficit; the subdued inflation outlook; the sharp increase in foreign exchange reserves; and the appreciation and subsequent stability in the exchange rate”. Thereafter, the entire report is devoted to praising the government for its sound economic management and even the SBP itself takes credit for a turnaround in the economy.

But in reality all the developments originated from foreign inflows and not from policy reforms. Apart from the rebound in real growth which in fact did not take place, every other development owed its origin to foreign inflows. Private sector credit increased when the pre-emption of bank credit by the government fell due to larger foreign financing; fiscal deficit partly declined because of the Saudi grant; subdued inflation outlook is not there as yet except in the official price statistics; foreign exchange reserves went up because of foreign inflows, and the exchange rate appreciated because the government used the available foreign exchange to flood the market with dollars.

Moreover, all these trends are temporary and reversible if foreign inflows stop coming and structural policy measures are not taken. On the other hand, if foreign borrowing is continued, the country will be in the grip of a foreign debt trap and balance of payments crisis in the near future. Evidently, there have been no meaningful policy reforms to turn around the fundamentals of the economy. It is the impact of massive foreign inflows that is reflected in various sectors.

The SBP is a professional and not a political organisation and it must apply its available skills to tell the truth rather than to hide it. But it has turned out to be ‘more Catholic than the Pope’ in presenting a rosy picture of the state of the economy, while all that has happened is that massive foreign inflows have temporarily eased the pressures for structural policy reforms.