Reduce the rate

There is a lot of hue and cry on the steep rise of the policy rate from 5.75 percent to 13.25 percent.

The business community was not given any relief when the State Bank of Pakistan chose to keep the policy rate unchanged on November 22, 2019.

A policy rate of 13.25 percent means that the effective rate of borrowing is touching 18 percent, as commercial banks usually charge a premium of 3 percent to 6 percent on top of the interbank rate (KIBOR). KIBOR, which is currently around 14 percent, is usually higher than the policy rate to discourage the temptation of borrowing from the central bank and re-lending it to others at a higher rate. The plight of smaller and medium-sized businesses does not end here, as commercial banks charge them a heavy annual amount in the name of processing fee.

Interest rate, also known as discount rate, is an important monetary policy tool used by the central bank of the country to achieve several macro-economic objectives such as controlling inflation, influencing exchange rate, reducing unemployment and/or accelerating economic growth. The reasons often presented to defend the recent increase in policy rate in Pakistan were to reduce staggering import bill, control inflation, lower downward pressure on rupee-dollar exchange rate and build foreign exchange reserves. Let us examine how an increase in interest rate achieves these objectives.

Higher interest rates raise the reward for savings and discourage borrowing and consumption, especially of high-priced items, such as automobiles, electronics, designer clothing, luxury holidays, latest cell phones etc. It is believed that higher interest rates, along with higher import duties, help reduce imports. Additionally, higher interest rates help reduce demand inflation, as, unlike higher import duties, which compel consumers to switch from imports to locally made goods and may trigger inflation, higher interest rates lower the demand for both imports as well as locally-made goods. Thus, higher interest rate dampens demand and controls demand-pull inflation as well as reduces imports at the same time.

Higher interest rates raise the incentive to invest in rupees instead of dollars and encourage hot money flows (they are called hot or speculative money flows, as, unlike Foreign Direct Investment, they are expected to stay in an economy for a short duration of time), as long as the possible gain of interest rate on rupees is enough to outset any gains through dollar appreciation.

For example, a possibility of earning 12 percent on the rupee account will encourage inflows in rupees account as long as it is believed that the value of dollar against rupee will remain less than 174 rupees for one year ie 12 percent depreciation of rupee against dollar. It is being observed that the combination of higher interest rates and a relatively stable exchange rate is discouraging speculative buying of dollars and helping build reserves of foreign currencies.

However, like every other macroeconomics tool, raising interest rates has some trade-offs too. Higher interest rates discourage borrowing and businesses are forced to review expansion and growth plans, as not only does their cost of borrowing rise but the demand for their products also falls as consumers prefer to save instead of spend. This not only slows down economic growth but also raises unemployment. Businesses that have already borrowed face a possibility of bankruptcy, as they become unable to serve the debt when the costs rise well beyond their forecasts. Another consequence of higher interest rates for a debt ridden country like Pakistan is that the government expenditures increase on debt servicing. Expenditures of Pakistani government rise by more than 200 billion rupees whenever the policy rate is raised by 1 percent.

In the last few months, the economy of Pakistan has shown some positive signs, such as improvement in current account balance, build-up of foreign exchange reserves, a stable exchange rate (the rupee actually gained against the dollar) and a relatively high expected growth rate of 3.4 percent in comparison with earlier forecasts of 2.5 percent.

In light of these positive signs, it is reasonable to expect that the State Bank should now decrease the policy rate to shift its emphasis to accelerate economic growth and job creation. The decrease in interest rate will also provide fiscal space to the government, allowing it to allocate more resources for poverty alleviation and social sector development.

However, the State Bank chose to keep it unchanged mainly because of the rising inflation rate. The Bank believes that to encourage savings, it is important that savers must get a rate of return in excess of the inflation rate. Real interest rate, which is the excess of interest rate over inflation rate, in Pakistan, is still 1 to 2 percent, giving the State Bank a strong reason not to lower the policy rate as long as the inflation rate does not come down.

One must not forget, though, that the current inflation in Pakistan is not demand-pull but cost-push and that the monetary policy instrument of higher interest rate is not effective to curb cost-push inflation. The core inflation (which, unlike headline inflation, ignores a hike in food or oil prices because it is caused by reasons beyond the control of the central bank, such as a crop failure or a ban on imports) in Pakistan is still in single digits and the rate of interest should be in line with it and not determined by headline inflation. For example, in India the policy rate is still 5.15 percent even when food inflation is in excess of 10 percent.

There is no public policy that is absolutely good or completely bad. There exists a strong case for reducing interest rates in Pakistan to accelerate economic growth and for job creation. On the other hand, the regulatory framework of local and provincial governments should play its role to prevent exceptional rise in food prices.

The writer is a freelance contributor. Email: kamran@kims.edu.pk