Interest rates: no more room for tightening

Interest rates in Pakistan are almost at historic highs and still the country is running negative real rates on both current and forward-looking inflation. Some believe that the interest rates should be in the positive territory to bring inflation under control while others are of the view that cost push inflation may not be tamed by rising interest rates.

Let’s try to evaluate the merits and efficacy of further raising interest rates on controlling inflation. The prime objective of raising interest rates is to curb demand through lowering the pressure of borrowing and the other important element is to provide real returns for savers adjusted for inflation. Here, I attempt to dissect both sides and evaluate the efficacy of monetary tightening.

On the credit side, the dominant borrower is the government of Pakistan. The government borrowing from commercial banks is three-fourths (76 percent to be precise) of total banking deposits and half of the banking assets (48 percent to be exact). In terms of share in broad money (M2) stock, the government borrowing is 72 percent, and another 6 percent is doled out to public sector entities.

The question is whether the government spending behavior can be impacted by the change in the interest rates. In the past, history (including more recent times) suggested that the government borrowing and spending are largely insulated from interest rates. That seriously limited the efficacy of conventional monetary tightening on the overall credit behavior and money creation.

Credit to the private sector is 32 percent of the broad money and 28 percent of banking net domestic assets (NDA). And within private credit, 15 percent is concessionary finance. The total private credit doled out is Rs9.2 trillion and out of which Rs1.6 trillion is concessionary finance in the form of TERF, ERF, LTTF and other schemes, and in all these schemes, the liquidity is provided by the State Bank of Pakistan and risk is assumed by banks and other financial institutions.

Thus, private credit linked to the policy rate is around one-fourth of the broad money. And within this private credit, 8 percent is extended to the power sector where the finance cost is a pass-through item and projects are covered by sovereign guarantees. Here, an increase in policy rate does not lower the demand but would contribute to the circular debt and eventually result in an increase in energy tariffs.

The share of private credit in Pakistan is much lower compared to both developed and other developing economies. For example, domestic private credit to GDP is over 200 percent in the US and over 100 percent in many other developed countries while the ratio is over 50 percent in India and approaching 50 percent in Bangladesh. In contrast, private credit to GDP is under 20 percent in Pakistan and it at its best was 27 percent in 2007.

Then the composition of private credit is skewed towards manufacturing in Pakistan which is almost two-third of the total private credit pie. And LSM growth has already nosedived due to import restrictions and overall demand destruction. Players are selling assets to shave off bank loans and some may default on repayment due to growing finance cost.

Then the consumer finance is a mere 10 percent of the private credit, 3 percent of broad money and even lower share of total domestic credit. There is not much room here for further decline and it’s already down by 3 percent this fiscal year.

Moreover, broad money supply growth is at 15 percent this fiscal year so far while the inflation number last recorded at 36 percent implies that real money growth is deep in the red and it reflects a sharp dip in the real money supply.

That is the story of the credit and there is not much to curtail by further increase in the rates. Another way to look at it from Pakistan’s perspective is to curtail current account deficit and that is lately in surplus, even after lifting the import restrictions, the balance is likely to remain tamed.

There is another way to look at the efficacy of curbing demand on inflation through the composition of inflation basket. Over 30 percent of urban and 40 percent of rural basket comprise of food items. And prices in the food value chain are in many ways controlled by the government. For instance, provincial governments fix the support price for both wheat and sugar.

And district management attempts to control retail prices of numerous food items. Without debating the distortions created due to such practices, not much can be done to control food prices by raising interest rates.

The other argument hawks present is that savers are at a disadvantage by having negative real rates. Indeed, they are. Inflation is expected to be around 30 percent while bank deposits are offering at best 20 percent.

However, large part of the economy is informal and not part of the banking system. This is evident by extraordinarily high currency in circulation which is 44 percent of bank deposits and 30 percent of broad money supply.

That is probably one of the highest in the world. And this informality or infirmity in the economy has been growing in the past few years (and quarters) despite high interest rates and depreciation of Pak Rupee. This implies that informal actors prefer to remain outside the system for a host of reasons (mainly to remain out of the tax net) and are not lured by better returns offered by bank deposits or other formal saving avenues linked to the interest rates.

Then the poor are financially excluded (do not have bank accounts) – there are only 67 million unique bank accounts in a population of 230 million or so. And many of those who have bank accounts are walled off from conventional interest-bearing deposits due to religious reasons.

The ratio of current deposits (zero return) is about 40 percent of total deposits. These are insulated from any increase in the interest rates. And then there is growing tendency towards moving to Islamic banking where the saving accounts are offering 6-8 percent return versus 18.5 percent on conventional saving accounts. Lately, banks are silently trying to forcefully convert conventional saving accounts to current. Thus, the argument of supporting savers is not very strong in Pakistan’s context.

Now the main argument remaining for increasing interest rates is to not let the currency depreciate further. However, with tamed current account, there is not much demand of foreign currency in the interbank market. That is evident by improvement in SBP’s net forex derivatives position where the net short position is lowered from $5.7 billion in Feb 23 to $4.8 billion in March 23.

The other way to gauge better USD supply is by looking at PKR/USD forward premiums which have sharply increased since Feb 2023. And if still there is any demand in the open market that is due to the fear of economic default which can only be lowered by bringing political stability.

The key to avert default and to control the overall system credit is by putting the fiscal house in order, and there is not much that can be done by the central bank, and a few monetary policy members – both from the SBP and independent members, privately share such frustrations.

The need is to focus on where the problem is and the efficacy of monetary tightening in case of unresponsive fiscal policy is limited beyond certain nominal rates which are already hovering at historic highs.

Moreover, cost push inflation may come in control if the currency is not allowed to slip further. One way is to look at the Sri Lankan example where the policy rate is below 20 percent and inflation has started tapering off from its peak of 70 percent in September 2022 to 35 percent in April 2023. Pakistan’s inflation number is expected to peak in May 2023 to around 38-40 percent before tapering off provided there is no fresh round of currency depreciation.

Then there are talks about external debt restructuring in Pakistan and external debtors may ask similar treatment for domestic debt where restructuring would essential mean lowering the effective interest rates on government borrowing either through haircuts or lowering net present value (NPV) of bonds. With lion’s share of system credit to the government and tapering off the private credit due to falling economic growth to negative, there is not much merit in raising interest rates further.

Copyright Business Recorder, 2023