The Reserve Equation and The Analytics of Pakistan's Monetary Policy

This paper deals with the computation and analysis of some fundamental reserve aggregates and associated monetary statistics which impart important information regarding the design and conduct of monetary policy at the State Bank of Pakistan. Specifically, we compute the data series for borrowed, unborrowed, free and drainable reserves using balance sheet data published by the State Bank of Pakistan for the period 1985-2009. Results show that Pakistan’s monetary policy revolves around managing the exchange rate while using the t-bill rate as the key policy instrument. However, the value of the t-bill rate is both incorrectly and sub-optimally related to macroeconomic fundamentals rendering monetary policy time inconsistent. This hinges on the finding that since 2000-01, State Bank of Pakistan is targeting net free reserves of the banking system at 4% of total private deposits. Among other observations, we find that the scope of open market operations as a tool of monetary policy remains but limited and that this limited role of open market defenses derives from an indiscreet concern of the central bank to sterilize its own foreign exchange reserves. Furthermore, the growth rate of unborrowed plus drainable reserves bears a strong negative correlation with the annual average rate of inflation, which, on account of the former being consistently negative since 2005, implies that the government and the State Bank of Pakistan both have absolutely no concern for controlling inflation.