Nida Ali

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Assignment no 2
Pakistan's economy has a long and complex history that dates to its independence from British
colonial rule in 1947. Initially, the country's financial market was relatively underdeveloped,
with limited infrastructure and institutions. However, in the decades following independence,
significant efforts were made to strengthen the financial sector, including the establishment of the
State Bank of Pakistan in 1948. Despite these efforts, Pakistan's financial market still faces
significant challenges today. The market remains underdeveloped, with limited access to capital
and inefficient resource allocation. Furthermore, the tightly controlled monetary policy has
limited market flexibility and innovation, which is crucial for economic growth. The challenges
facing Pakistan's financial market have had a direct impact on the economy. Inflation has
remained high, and the national savings rate has been consistently low, leading to a decline in
living standards and foreign investment. Therefore, it is crucial to develop a comprehensive and
strategic approach to address these challenges and promote economic growth. (Zaidi, 2015)
In the case of Pakistan, the financial sector has been heavily influenced by government planning
processes. The government has been the primary agent in financial control, with state-owned
institutions like the Nationalized Commercial Bank and Development Financial Institutions
accounting for over 60% of all deposits. Government bonds are also used primarily for financing
the deficit of the country and account for more than 40% of financial wealth. This policy of
government control has led to increased losses in the financial sector, which must be covered by
depositors. The lack of competition and innovation in the sector, as well as increased government
ownership of financial institutions, has made it difficult for private banks to thrive. This has
resulted in a banking system that is less efficient than it could be, with a limited range of services
and high costs for consumers. Despite these challenges, there have been efforts to promote
greater financial stability in Pakistan. In recent years, there has been a move towards greater
financial inclusion, with the government working to increase access to banking services for those
in rural and remote areas. There has also been an effort to formalize informal or curb markets
that have developed in response to the lack of financial instruments and market rates of return in
the country. These markets have sought to circumvent official controls and provide market rates
of return to investors. However, they have been viewed with suspicion by many government and
donor organizations. (Haque)
Pakistan’s economic problems are compounded by a range of specific factors, including political
instability, efforts to prop up the currency, and lower demand for exports due to the global
economic slowdown. The country has been experiencing a balance-of-payments crisis, which
means that it has been spending more on imports than it is earning from exports, resulting in a
decline in foreign reserves and a weaker exchange rate. This has made debt servicing more
expensive, increasing the cost of imports and further reducing foreign reserves. The country's
central bank has raised its key interest rate to 17% to counter the high inflation rate, which is
nearly 28%. This move has made borrowing more expensive, reducing investment and further
slowing down the economy.

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In addition, historic floods and the pandemic have added to the strain on the government budget,
with the World Bank estimating that at least $16 billion is needed to cope with the damage and
losses. The economic slowdown has also reduced demand for Pakistan's exports, while the sharp
rally in the value of the US dollar last year has increased pressure on countries that import
significant volumes of food and fuel. The combination of high debt levels, lower growth, and
higher borrowing costs has made vulnerable economies like Pakistan even more susceptible to
financial stress. The IMF has warned that 15% of low-income countries are already in debt
distress, while another 45% are at high risk of struggling to meet their obligations. An additional
25% of emerging market economies are also at high risk. In this context, Pakistan's
underdeveloped money market has contributed to the high inflation rate and low national
savings. The country's limited financial infrastructure and inadequate institutional frameworks
for financial intermediation have prevented the development of a robust money market that could
support investment and savings. This has made it difficult for the government to mobilize
domestic resources to finance investment and meet its debt obligations. Moreover, the controlled
market policies have also discouraged savings and investment by keeping interest rates low,
reducing the incentive to save and invest in the formal economy. This has led to a significant
portion of the economy operating in the informal sector, where transactions are made in cash and
remain outside the formal financial system, making it difficult to mobilize domestic resources for
investment and economic growth. (Saifi, Feb 2, 2023)
Inflation in Pakistan has been on the rise since 2018, with the inflation rate reaching its peak in
2020 at 9.1%, which is the highest in a decade. The money market has played a significant role
in this situation by contributing to the increase in interest rates, the rise in government
borrowing, the devaluation of currency, speculative trading, and the lack of investment in
productive sectors.
One of the main reasons for the high inflation rate in Pakistan is the increase in interest rates.
Let’s consider an example. Suppose the SBP raises interest rates to control inflation, which
results in a decrease in the money supply. As a result, businesses and individuals are less likely to
borrow money from banks, as the cost of borrowing has increased. This decrease in borrowing
leads to a decrease in investment and consumption levels. Businesses may be less likely to invest
in new projects, as they will have to pay higher interest rates on their loans. Similarly,
individuals may be less likely to take out loans for big-ticket purchases, such as homes or cars, as
the cost of borrowing has increased. The decrease in investment and consumption levels leads to
a decrease in overall demand for goods and services. This, in turn, leads to lower economic
growth, as businesses are not producing as much as they could be, and job losses, as businesses
may have to lay off employees to cut costs. The impact of higher interest rates on the financial
markets is also significant. Investors are less likely to invest in stocks and bonds when interest
rates are high, as the returns on those investments become less attractive. This can lead to a
decrease in stock prices, as there are fewer buyers for those stocks. Additionally, higher interest
rates can lead to a decrease in foreign investment, as investors may choose to invest in countries
with lower interest rates, leading to a decrease in the value of the Pakistani rupee. Finally, the
decrease in overall demand for goods and services leads to lower inflation rates. This is because
there is less demand for goods and services, leading to a decrease in their prices. While lower

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inflation is beneficial in the long run, it can also lead to deflation, which can hurt the economy,
as it may lead to a decrease in overall economic activity.
Speculative trading has also contributed to the volatility of inflation rates in Pakistan. Let's say
that an investor in Pakistan wants to engage in speculative trading in the money market. They
believe that the Pakistani rupee is going to depreciate soon, so they decide to sell their rupees and
buy US dollars instead. The investor then uses the US dollars to buy assets in Pakistan, such as
government bonds, with the hope of making a profit when they sell those assets in the future.
However, if other investors also start selling their rupees and buying US dollars, it can lead to a
decrease in demand for the rupee and an increase in demand for the dollar. This, in turn, can lead
to a depreciation of the rupee. As the rupee depreciates, the prices of imported goods, such as oil
and machinery, also increase since it takes more rupees to buy the same amount of dollars
needed to purchase those goods. This can lead to inflation, as the prices of goods and services
increase in response to the increased cost of imported inputs. Additionally, when investors
engage in speculative trading, they often focus on short-term profits rather than long-term
investments. This can lead to a lack of investment in productive assets, such as factories or
infrastructure, which could contribute to long-term economic growth and stability.
In conclusion, efforts must be made to develop financial institutions and infrastructure, and
policies that promote innovation and flexibility in the financial sector must be implemented. The
government's recent reforms in this regard have shown some promising results, but more needs
to be done to ensure sustainable economic growth and development. By addressing these
challenges and unleashing the full potential of its economy, Pakistan can achieve long-term
prosperity and improve the quality of life of its people.

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References
Haque, N. U. (n.d.). Financial Market Reform in Pakistan. JSTOR.

Saifi, S. (Feb 2, 2023). Blackouts and soaring prices: Pakistan’s economy is on the brink. BBC.

Zaidi, S. A. (2015). Issues in Pakistan Economy. Karachi: Oxford Press.