A regressive interest rate policy

Against the backdrop of international price hikes and unprecedented floods, the economic outlook for Pakistan in the current fiscal year (2022-23) is likely to remain bleak, according to the ‘Economic Update and Outlook for September 2022? released by the finance ministry. Pakistan’s debt has increased from around USD 48 billion in FY08 to USD 116 billion – an increase indicating a structural deficit of at least USD 5 billion per annum in Pakistan’s economy.

The country is in need of a focused programme of export enhancement that can ensure this deficit is met each year. However, the economic downturn has severely hit the textile sector, Pakistan’s largest exporting sector, with more than 1600 factories already closed and more to follow. In the current environment we can expect 3-5 million direct job losses, leading to extreme social distress and what can only be called a self-inflicted calamity comparable to the recent floods in terms of economic destruction.

The situation is exacerbated by the misinformed and regressive policy of maintaining a high interest rate to counter inflation. Exporters’ working capital requirements have increased manifold and the requisite finance is not available, and when available it is extremely costly given the unreasonably high interest rates which no industry can afford. Without the operation of textile exporters, there will be no means of meeting the country’s forex requirements or balancing the current account.

Given this abysmal state of affairs, the need for a long-term policy featuring lower interest rates is crucial, and its implications for a brighter economic future which generates foreign currency, jobs and international recognition cannot be denied.

To expand our export base and address the structural imbalance, Pakistan needs higher levels of investment, alongside holistic policy reforms that lend confidence to investors and the markets. This need cannot be met with an interest rate of 15% and an unsustainably high dollar rate.

Central banks across the world have been raising interest rates to tame inflation, but this monetary policy fails to account for supply shock disruptions. Pakistan’s interest rate remains elevated at 15%, thereby hurting businesses and stifling investment and entrepreneurship. The annual inflation rate in Pakistan increased to 27.3% in August of 2022, the highest since May of 1975, from 24.9% in July, the Pakistan Bureau of Statistics reported.

Pakistan’s interest rate has intentionally been maintained at a high level in miscalculated attempts to control inflation, by means of a contractionary monetary policy. Although policies of this nature have been effective in reducing inflation for certain Highly Developed Economies, there is no evidence to suggest the same rules apply to the case of Pakistan.

On the contrary, it is proven that a high interest rate in Pakistan leads to an increase in cost-push inflation.

This belief was emphasized by Nobel laureate Joseph Stiglitz, who recently described how within the US economy and others possessing market power, companies can afford to raise prices without losing business. Meanwhile, standard economic models suffer from even more inflation when subjected to rate hikes.

Contractionary monetary policy operates by decreasing the money supply in order to increase the cost of borrowing. This measure normally decreases GDP and dampens inflation. The State Bank of Pakistan chose to maintain a high interest rate, decreasing the money supply in attempts to curtail inflation. However, the opposite impact has been observed in Pakistan’s case, as here there is a directly proportional relationship between inflation and discount rate.

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Country       Interest Rate 
               % (July 2022)
============================
Pakistan                  15
Sri Lanka               14.5
Bangladesh                 5
India                    4.9
Vietnam                    4
============================
Source: tradingeconomics.com
============================

A high interest rate is one of the major roadblocks to entrepreneurship and innovation that needs to be mitigated so that we can empower our youth and our disenfranchised talent to bring about a grassroots level economic revolution.

Furthermore, we must rid our policymaking of the economic formula whereby interest rates are raised in order to stabilize the economy, as this can only be effective in certain Highly Developed Economies: a title which Pakistan’s economy is a long way off from attaining.

HDEs tend to have surplus currency tied up in mortgages or consumer financing. Therefore, it is only logical that such a formula be limited in its application to those economies which are in a similar state, while a policy more suited to developing economies should be used in Pakistan’s case.

The best mechanism is through supply-side interventions, bringing more individuals into the economy and increasing the labor supply – for which entrepreneurship and financial inclusion is critical. High interest rates not only curtail investment, but also make it virtually impossible for the concerned industries to remain profitable.

The spike in interest rates has all but put a complete stop to investment, upgradation and technological advancement in various industries. Pakistan’s interest rate is now the highest in the region - even higher than that of Sri Lanka, which is reeling from a default on its debt.

One of the biggest difficulties the sector faces is finding a steady supply of high-quality raw materials at reasonable rates. This is because the exporting sectors’ inputs (raw materials, energy, dyes and chemicals, machinery, and spare parts etc.) are valued in dollars in order to reduce the risks associated with currency volatility and to create a stable and secure environment for business. Industries are vertically linked, so imported inputs become more expensive for any given exporter and are not always interchangeable with domestically produced goods.

The government borrowing is around 80pc of its nominal GDP, so high interest rates only serve to raise the country’s own costs, and are therefore highly counterproductive. The increase in debt servicing from Rs 3 trillion to Rs 4.8 trillion as a consequence of the increase in interest rates from 7% to 15%+ has a direct impact on the budget deficit. This negates any possible impact on curtailment of demand, and consequently a policy of raised interest rates is not suitable for Pakistan.

A more adaptive financial model and a focus on more productive capital investments, particularly in technological improvements, will have a wide, far-reaching impact that will bear fruits for generations to come. It will allow for a much-needed increase in our presently abysmal level of exports, and will also tackle the increasing burden of unemployment at the root.

The provision of RCET over the last 3 years has been a resounding success. Textile exports have grown from $12.5 billion in FY20 to $19.54 billion in FY22 – a very significant increase by any yardstick and well above our regional competitors.

This export spur has occurred due to the focus of the government to provide regionally competitive terms for the sector to remain competitive. Although providing RCET is not a subsidy, the cost of RCET to the national exchequer has been 2.6% of export value over the last 3 years. This compares very favorably with sukuk bonds and other borrowings where dollars are borrowed at 8% and have to be returned.

The only option for a sustainable economic future for Pakistan lies in building a strong export base thereby minimizing our reliance on foreign aid, which impairs our sovereignty.

A strong export base necessitates consistent supply of energy at regionally competitive rates. Furthermore, the government must focus on implementing a practical approach toward resolving policy concerns, and crystalizing a functional structure where all the stakeholders especially Pakistan’s business community must be brought on board during negotiations with international financial institutions to chalk out a consensus and steer the country’s economy out of crisis.

Copyright Business Recorder, 2022