Businessmen think that the nominal increase in the State Bank of Pakistan’s (SBP) policy rates would adversely impact investment, while most economic experts are of the view that the increase is too low to fight the current inflationary pressures.
Policy
Businessmen think that the nominal increase in the State Bank of Pakistan’s (SBP) policy rates would adversely impact investment, while most economic experts are of the view that the increase is too low to fight the current inflationary pressures.
Businessmen always want credit to be available at very low mark-up. They, however, did not take advantage of the lowest policy rate of 5.75 percent announced by the central bank in May 2016.
Since then inflation was on the rise and an increase was expected much earlier than announced on January 26, 2018. One fails to understand the criteria that the SBP adopts to contain inflation.
It is interesting to note that the inflation touched a low of 1.3 percent in September 2015 but the policy rate was kept at six percent, it was decreased by 25 basis points in May 2016 to 5.75 percent when inflation crossed 4.2 percent.
In the terminology of economists, the difference between demand and the economy's capacity to supply is known as the output gap. Monetary policy can't influence the economy's capability to supply. This way monetary policy acts as an instrument to stimulate or dampen demand. The central banks achieve this objective by adjusting short-term interest rates. Higher rates do slowdown growth but if the inflation is allowed to step up, it ruins the economy. It is wiser to go slow in lowering the policy rates when the inflation is declining, however as the inflation starts increasing the central bank should act quickly.
Inflation remained low in Pakistan not because of domestic policies of the state, which were inflationary. The high fiscal deficit that this regime carried from the Pakistan Peoples’ Party era continued to balloon up in the last four years. This alone should have kept inflation in double digits but this was averted due to external factors like very low crude oil and commodity rates for almost three years. These rates started moving up in the last 18 months.
As all central banks know the sensitivity of the businesses to increase in policy rates, many of them use other tools to control money supply. There are three major monetary tools that a central bank can apply to control inflation. These include adjustment in interest rates, cash reserves requirement and statutory liquid requirements.
In order to control the circulation of money in the system, the central bank has the option to increase or decrease the percentage of cash that banks have to compulsorily keep with the central bank. If inflation is expected to go up, the central bank could nominally increase the policy rates and increase the cash reserve requirement (CRR) for all banks by one or two percent. This will suck lot of liquidity from the system and contain inflationary pressures.
However, if inflation is under control and the system needs liquidity, the central bank could lower the CRR. This tool was used by the central bank in Pakistan during the tenure of Shaukat Aziz when CRR was both increased and decreased. It has not been used during past one decade. The Indian central bank used this tool to inject or withdraw liquidity from the system regularly.
The other tool is the statutory liquidity ratio (SLR) under which the central bank determines reserve requirements on the amount of money banks are legally required to keep on hand to cover withdrawals. The more money banks are required to hold back, the less they have to lend to consumers. If they have less to lend, consumers will borrow less, which will decrease spending and control inflation. This tool was also last used by the SBP during the Shaukat Aziz era. The CRR and SLR do limit the banks from using their deposits for lending, but this is also a safeguard against over lending.
The threats of inflation are there as is conceded by the central bank’s monetary statement. The current situation demands that precautionary measures are taken before the inflation monster goes out of control. Increasing policy rates by mere 25 basis points would not work, but it would definitely provide relief to the government that is the largest borrower of commercial banks.
To thwart the impact of impending inflationary pressures the interest rate should have been enhanced by 1-1.5 percent on fresh borrowing and over Rs100 billion on its existing domestic debt. The central bank for now saved the government from an addition in the debt servicing burden by nominally increasing the policy rates.
Inflation takes place when an economy grows due to increased spending. In Pakistan, this increased spending is due to huge budget deficit. The central bank still lacks autonomy. It has full autonomy to increase and decrease policy rates but it has to oblige the state if it is asked to print notes to cover its budgetary deficit.
It was agreed in principal between the donor agencies, government of Pakistan and central bank that the government would refrain from asking the SBP to print notes. Instead, it was decided that the government of Pakistan would cover its fiscal deficit through borrowing from commercial banks.
The main object of this procedure was that since commercial borrowing is expensive and adds more burden on the country’s sovereign debt, the government would slowly reduce commercial borrowing and increase revenues. However despite increase in tax revenues the bank borrowing of the state from banks did not decrease. This has crowded out finances for the private sector. The banks feel comfortable in lending to the government because it is risk free.
Whenever the inflation dips a bit there are screams for reduction in interest rates. Businessmen fail to realise that a premature reduction in interest rates would never kick start the economy. When inflation rises they urge the central bank to hold the rates as they have been doing in the past one year and SBP has been obliging them.
It may be pointed out that increasing interest rates does not impact cost as much as the increase in input costs due to higher inflation. Interest cost is not more than 10 percent of the total cost of a business. Cutting/increasing the interest rates by one percent would reduce/increase the production cost by 0.1 percent and a two percent decline/increase would bring down/up the overall cost by 0.2 percent. These savings could be achieved by improving inefficiencies.
Instead of wasting their energies on reduction in interest rates the businessmen should press the government to improve governance and delivery of services; that could provide a reprieve of three to five percent in their costs.
When interest rates are low the banks adjust deposit rates accordingly, pushing the savers to look for other unproductive avenues of investment.
The central bank has to decide the permissible inflation limit for the economy. For this fiscal it is six percent. Keeping policy rates at six percent would condition the economy at six percent inflation and risks of going up would be higher.
The writer is a staff member
