A policy for the policy rate

A reduction in the policy rate is the only way forward in a country where the government is the top borrower

A policy for the  policy rate


he policy rate is an important monetary policy instrument that controls the money supply in the market. This is the reason why the State Bank of Pakistan keeps changing the policy rate, although this only causes the prices to change and the GDP remains fixed in the long run. However, this does help the government achieve its short-term targets like inflation and growth.

When the State Bank reduces the policy rate, it reduces the cost of credit and increases the supply of money to the market. As people get more money, the demand for goods goes up and so do the prices. “Inflation is too much money chasing too few goods,” if people have more money and the goods produced remain the same, demand-pull inflation comes into play.

If the SBP tightens the policy and raises the rate, consumers are less likely to seek loans from banks. Investors start preferring to invest in banks than investing in businesses. But this is not the end of the story. A rise in interest rates also reduces the purchasing power of those who have already borrowed from banks and eventually reduces the demand for goods in the market.

However, Pakistan’s case is quite different. In the rest of the world, most businesses, as well as individuals, are heavily indebted to banks in the form of business and individual loans (house loans, study loans, credit card loans etc). In these countries, if the policy rate is raised by 1 percent, many people are out of money, resulting in reduced demand, further resulting in reduced inflation.

In Pakistan, only 21 percent of the public has access to banks and less than 60 percent of the economy is documented. Moreover, unlike some other countries, most individuals are not indebted to banks. Therefore, a rise in the interest rate does not impact the commoner spending as much because there is no interest cost involved.

However, with every 1 percent rise in the policy rate, the government, the largest borrower, has to bear an additional burden of more than Rs 200 billion in the form of additional interest costs. This causes a fiscal deficit, financed by taxes and raises the fuel and electricity costs.

Therefore, by raising interest rates, the economy suffers in three ways: by paying more taxes, by reducing investment from loans and by paying more in energy costs. This phenomenon is evident and quite clear from the economic indicators in the past.

We have raised the policy rate from 5 to 16 percent over the past 4-5 years to please the IMF. The economic czars of the country must be able to demonstrate to the IMF that the formula of raising interest rates to control the money supply is ineffective in Pakistan’s case. It is severely hurting the sustainability of the national economy.

By raising interest rates, Pakistan’s economy suffers in three ways: by paying more taxes, by reducing investment from loans and by paying more energy costs. This is evident and quite clear from the economic indicators in the past. 

When the rates are lowered, demand grows faster than supply and causes a balance of payments crisis. But there are other ways the government can respond to this issue than by increasing the policy rate every time there is a balance of payments crisis.

In the current scenario, as Pakistan is short of foreign exchange, we have to control only Pakistan spending outside Pakistan by lowering the cost of domestic production. The current policy of restraining demand by raising taxes and energy prices is counter-productive.

Pakistan’s energy sector depends heavily on imported fuel, which consumes most of our foreign exchange. Since June, Pakistan has imported goods worth $25 billion, including $8.8 billion of fuel. We are spending 35 percent of our foreign exchange on fuel imports.

To avoid this massive outflow of foreign exchange, we must minimise dependence on imported energy. The government needs to improve public transport, subsidise solar financing and run an awareness campaign to save energy. Pakistan lags far behind the world when it comes to energy efficiency. As per World Bank ranking of regulatory indicators for sustainable energy, Pakistan scored 31 out of 100 in the efficient use of energy.

Amongst other policy steps, we should move the transport of goods from trucks to railways. Pakistan railways have always incurred losses in passenger transport but have been profitable in goods transport. We can save a substantial amount of imported diesel and spare parts of trucks if we can take policy measures to transport goods through railways.

While this may not be possible for all types of goods, transportation of a specific class of goods, like industrial raw materials, construction materials, coal and fuel, through railways should be made mandatory.

Some of the country’s wealthiest people are shifting their foreign exchange deposits outside Pakistan in the panic over default concerns. This is adding to the problems. A significant fraction of the remittances is also being carried through hawala. The government must stop the flight of money abroad.

A reduction in the policy rate is the way forward as the government is the top borrower in the country. Why pay more interest when you can get loans at lower rates?

Nauman Ali holds a bachelor’s degree in economics and law. He can be reached at ca_numan@yahoo.com

Nauman Rafique is a partner at Suriya Nauman Rehan & Co, Chartered Accountants. He can be reached at nauman_73@yahoo.com

A policy for the policy rate