SBP moving too fast?

With a 0.5 percent cut announced on Saturday; the Monetary Policy rate is now six percent. This should be the end of the easing cycle. There were expectations that the central bank would opt to lower the rate. So much was apparent from the yields of government papers. Three-fifths of the research houses and treasury departments contacted by BR Research had expected a 50 bps cut. However, there was little rationale to do so.
Since November 14, the State Bank of Pakistan has already eased the policy rate by 350 bps. The resultant impact of this easing to monetary demand occurs with a lag. The central bank should have waited a bit to see its impact before further easing. But it didn't and now the policy rate is 400bps lower than what it was in November. There are expansion plans in various sectors such as power, cement, steel and other industries and these will create credit demand soon.
The rationale presented by SBP is rather dovish -"Moreover, monetary conditions, despite easing, still appear to be tight as real lending rates are hovering around 4 percent since December FY15 due to rapidly falling inflation", emphasised MPS.
Inflation is down thanks to falling commodity prices; the volatility is high and prices may move up to make the argument of high real rates irrelevant. The real rates are high in many regional economies - India (3.5%), China (3%), Sri Lanka (7.7%) and Thailand (2.6%); to name a few . But not all are responding with large cuts in interest rates. It is also pertinent to mention that the fiscal deficits in all of the economies mentioned above; are less than Pakistan's. Hence, the fears of resurgence of inflation are relatively high here.
Many economies are attempting to counter the slide in commodities through correction in their domestic currencies. In the last two months, the Indian Rupee is down by 4.2 percent against USD; Chinese Yuan is lower by 2.9 percent; the Thai Baht is down by 6.9 percent while the Malaysian Ringgit is down by 14.7 percent. In a comparable time span, the Pakistan Rupee is down by just 2.5 percent. This is a dangerous policy mix that the central bank has deployed, by lowering rates unprecedentedly while not letting the domestic currency correct. It may boost domestic credit demand but it will not help restore lost competitiveness in the international market. With an improved security situation in Pakistan, the capital flow is likely to be porous. If the interest rates too low; the capital may move out and foreign exchange reserves may fall.
The argument for Pakistan to have aggressive cuts in monetary policy is that the country does not have space to provide fiscal stimulus to generate economic activities whilst the economic growth in the past decade has remained much lower than the regional economies. There is a dire need to generate growth and the monetary stimulus is in the offing.
Reduction in the discount rate by 400 basis points in ten months is too much. There is a need to wait to see its translation in terms of demand for credit. There are plans for expansions and for green filed projects - investment will start pouring in soon in sectors catering to domestic demand. The central bank is hopeful over value-added textile exports as economic conditions in developed economies improve, especially in the US. However, there are fewer hopes for low value-added textile exports and other exports from other sectors.
The monetary policy transmission is limited in times when there is heavy government reliance on the banking system. This is the case in Pakistan. Lowering of interest rates would not do much good as long as the banks are fixated with risk-free lending to the government. The government has to put its house in order to let the privet sector benefit from the excessive easing in the monetary policy.
The other problem created by low rates affects banks' ability to raise deposits. The currency in circulation has increased in the last year as people are less inclined to put their savings in the banks. The newly imposed tax on banking transactions has exacerbated the situation further.
There is a limit to the effectiveness of monetary easing and SBP appears bent on exhausting it. It is time now, to wait and see and let the transition take place. The central bank must also keep a cautious look on inflation beyond November when the base effect reverses.