The monetary policy is due tomorrow and market pundits are expecting a non-conventional way of monetary easing this time around. Whatever those measures may be, easing is inevitable as the seven-month average inflation is down to 5.5 percent and is expected to fall further. The real interest rate, based on discount rate is too high. Based on the CPI average over the past three months, the real interest rate is currently about five percent. This high differential is making the discount rate irrelevant, similar to the 2002-04 periods.
The question is how much would the central bank want to soften its stance, what tool would it deploy and how effective it will be. Secondary market yields are already down 50 bps after incorporating the last easing of 100 bps which has set effective rates at eight percent while the discount rate is at 8.5 percent.
Banks are heavily invested in PIBs; Rs2.5 trillion issued in 2014 and all that is happening in banking is the trade of government papers these days. The central bank is continuously injecting liquidity in the market through open market operations. The frequency of OMOs has increased as well as the quantum which jumped to an average Rs700-800 billion which is continuously rolling.
The banks are using this money to grab as many PIBs as they can and effectively becoming investment banks for a single client (read government). The central bank is of course, facilitating the banks. Where is the financial intermediation? And what is the use of the discount rate?
Therefore, OMO rates have become the effective benchmark for bank’s overnight rates. Six-month KIBOR is lower than the discount rate since it is determined based on overnight banking rates which in turn are implicitly pegged to OMO rates. The idea is to announce OMO rate as the benchmark for making interest rate corridor meaningful.
The corridor was introduced in line with guidance from the IMF and the spread was kept at three percent between the ceiling (discount rate) and floor. The thought behind it was to bring the market rates somewhere in the middle of the corridor, but it has never happened and most of time the transactions were happening either at the ceiling or the floor. To make the corridor an effective tool, SBP has narrowed the width to 2.5 percent but that didn’t work either.
An unorthodox approach could be to make OMO the benchmark rates (effectively it is) and bring it down to 7.5 percent which will bring overnight market rates close to the middle of the corridor by keeping discount rate unchanged at 8.5 percent thus letting the market reach a new equilibrium in the middle of the corridor. This will be an effective 50 bps easing from prevalent market practices or 100 bps easing from the previous MPS.
The other option is to lower the discount rate by 50-100 bps and keep on implicitly pricing the market through OMOs rates. A 50 bps decline is already priced in and would not have any direct impact on yields and chances are that the market rates will come further down, albeit slowly, to make the discount rate irrelevant.
The market is expecting a cut of 50 bps based on a survey conducted by BR Research. We contacted 25 research houses, of which 20 are in favour of 50 bps cut while three expect a slash of 50-100 bps while two expect no change. Following is the summary of that survey:
“Subdued inflation is the primary consideration; and it is expected to stay low over the next 3-4 months. The market expects CPI numbers in March to be below three percent. Real interest rates are hovering around 5 percent which is much higher than the usual range of 2-2.5 percent; this leaves enough room for SBP to opt for monetary easing.
The only risk to inflation at this stage is the hike in gas tariffs which can fuel inflation and is considered to have a trickledown effect on other variables as well. Hence, a cautious approach would be a safer bet for SBP which means opting for a 50bps cut now and another 50bps cut in June.
Another factor justifying the rate cut is the comfortable reserves position. Foreign inflows are expected hence reserves position is likely to stay strong. The materialization of privatization deals will provide further impetus. In the latest T-bill auction, yields for 6M and 12M paper have declined. Current trends in yields and bonds hint that market has already incorporated 100bps cut. But it’s a longer term view. Any drastic cut of say 100bps will put pressure on currency and import cycle. A cautious approach is indeed warranted.
Some participants also hinted on the implementation of a target rate which will be announced tomorrow. According to them, with the announcement of a target rate, the SBP might keep the discount rate stable”.
BR Research thinks it’s better to introduce the benchmark rate and make it variable to not only reduce volatility but to make the interest rate corridor more effective. And bringing it to 7.5 percent would effectively constitute a cut of 100 bps from last review. That is still low as the market is reluctant to accept new trends of inflation and some fear inflation may bounce back. It’s an overhang of bad times, and people will take time to change their perceptions.
However, a more effective way could have been to look upon exchange rate as a pricing tool to adjust other variables. The rupee is grossly overvalued and due to this exports are stagnating while non-oil imports are up by 20 percent. The balance of payments comfort is coming in the form of one-off flows such as disinvestment, loans, CSF and gifts. That is not sustainable and interest rates cannot really be effective in the absence of a free float exchange rate regime. But we all know about the obsession of Finance Minister to not let the currency depreciate; so better live with interest rates as a policy tool.
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