Rise in three-month and one-year treasury bills cut-off rates by 100 basis points is a hint that the State Bank of Pakistan is not only controlling inflation rate but also wants to cap credit expansion. Salman Jafari, from Jahangir Siddiqui Capital Markets Ltd, said that the increase in the yields has re-affirmed the SBP's stance on fighting inflation. The stance of 'measured' tightening is currently in vogue. The latest increase in Pakistan T-Bill yields has come close behind the recent hike in the US Federal Funds rate which rose 0.25% to stand at 3% last week. Both the US Federal Reserve and the State Bank of Pakistan are fighting inflation in the hope of effectively neutralising the entrenchment of long-run inflation expectations.
The fundamental premise of this action is that the long-run inflationary expectations, once entrenched, lead to a systematic decrease in capital formation and choke off economic growth. The actions of the SBP may seem aggressive to some, but monetary tightening right now is better than taking more painful measures in the longer term.
The result of this auction has re-affirmed most analysts' expectations of another increase in the SBP Discount Rate in the near future. Historically, whenever the 12-month T-Bill has come within a 1% range of the discount rate, the discount rate has moved up. There are two questions on everyone's mind right now: will the discount rate increase again so soon after its last increase on 11 April 2005, and if it does what will be the quantum of the change this time. With inflation currently above 10.25% year-on-year and expected to rise a further 0.5% to 0.8% by the end of this fiscal year, it is unlikely that the tightening stance will be abandoned any time before the end of Q2 2005.
Building on this premise, we can expect to see the 12 month T-Bill rise another 1.0% to 1.5% by the end of October 2005 before the SBP puts rates on hold to assess the impact of its tightening.
The period in- between will probably see the discount rate move another 1% and stay on hold there. A discount rate of 10% gives the SBP more room to manoeuvre in the coming six to seven months without putting its objective of a sustainable long-term growth trajectory at risk.
Hasnain Imam, investment analyst at Arif Habib Securities, said that the central bank was adopting a more aggressive approach, not only to contain inflation but also to halt the ongoing credit expansion, which has broken all past records. This might even mean that, as a tool to contain inflation, SBP might raise the Statutory Liquidity Requirement (SLR) or Cash Reserve Requirement (CRR).
"We see the new regime to be an era of lenders' market, thereby moving away from the previous era of borrowers' market. For corporates, we see the honeymoon period to be over, while for banks, DFIs and leasing companies, an era of abnormal top-line growth is in sight.
"We foresee a high interest rate environment in the near future. Higher interest rates would lead to higher expected returns by investors. The surge in interest rates might be positive in the long term if it is able to control the overheated economy and restrain inflation. On a holistic note, power generation may remain unaffected by this surge in interest rates. The cement, textile and telecom sectors would bear the brunt of rising interest rate scenario in the country. However, the banks and financial institutions would turn out to be the beneficiaries of this rising interest rate scenario."
"We feel that SBP agonisingly wants to put a squeeze on banks' injudicious liberal lending policies, which have spurred inflationary pressures in the ongoing fiscal", said Faisal Shaji, research analyst at Capital One Equities. The upward shift in the yield curve is also reminiscent of what is seen in India. Furthermore, these rates are benchmarked for KIBOR, that are used as pricing mechanism for lending, thus restraining companies borrowing intake for working capital.
Textile sector may feel the heat, as some of the fresh bullet loans, as well as FAFB, against exports would now be given at a higher price. "Going forward, we can foresee a further but gradual increase as SBP is also mindful of achieving growth targets especially during FY06," Shaji said.
Ali Farid, economist at Alfalah Securities, said that interest rates are a tricky issue. "Unfortunately, not many in the equity market really understand its impact. Many analysts expect interest rates rise to spell doom and gloom on the economy and the equity markets. However, this is not so. The State Bank Governor has been maintaining that interest rates rise would not affect economic/industrial growth; and he is right. Investment decisions are based on real interest rates, and not on nominal interest rates.
Interest rates are an instrument, which the central bank uses to curb inflation in the economy. In Pakistan, the interest rates were negative, which had spurred excessive speculative borrowing (which had its impact on the real estate market).
"However, the rise in inflation, which resulted from excess money supply, created inflation, as more money was chasing lesser goods. The rise in inflation threatened economic growth by eroding purchasing power and increasing the cost of doing business.
"Now to control this problem, the SBP has been raising the interest rates. If the rise in interest rates reduces inflation, which it should, then it should positively impact the economy", Farid claimed.
"So, the market's growth would indeed be dampened by the rise in interest rates as, very simply put, there would be less money available for investment. However, in the long run, the direction of the stock prices is dependent on the earnings and financial health of the companies and the fundamentals of the economy and policies. Since all these factors would improve due to a reduction in inflation, the medium-term view on the stock market remains positive.
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