Once again, the economist community is busy in speculating how much the policy rate will fall in the upcoming SBP’s MPC meeting in early November. The anchor is the fall in the inflation rate to single digits in recent months.
The ideological hawks, including businessmen, and a populist government would like a steeper and a faster fall to prop up investment and growth, while the doves in the Washington consensus camp would want the SBP to move cautiously with slower and smaller adjustments.
Backed by the results of neo-classical dynamic quarterly time-series econometric model, and implicit pressure from the government, MPC would have its evidence based final verdict.
Moreover, current interest rates as an indicator for economic agents to decide the allocation of future investment vs consumption in a neo-classical world, lot depends on how correctly future expectations are made by them.
The above dimensions of interest policy broadly fall into two main categories: a) policy rate setting and b) effectiveness of downward or upward interest rate cycle. The two, however, are not mutually exclusive. Under a) questions to be considered are: Should the policy rate fall by 200 basis points or even more (as already being speculated) or less. If less, how much less: 100 or 50 basis points? With the economy in a downward cycle of interest rates, how far they should be lowered and how close to the inflation rate?
Should the interest rate charged to GOP recently by a foreign commercial lender mark the end of the downward domestic interest rate cycle? And in how many steps? If inflation from now on remains sticky downwards of its cycle how much more the interest rates should be lowered to discourage its upward march?
The IMF stance is that real interest rate should remain positive, meaning higher than the inflation rate. How much positive, in single or double digits to satisfy both camps? Under b) How does the downward movements in policy rate impact inflation in a supply constrained and demand push economy? If in a stylistic neo-classical framework it does raise the growth rate, what is the quality of that growth rate, productive vs non-productive casino type investments/consumption or private vs government investments?
What is the benchmark policy rate that allows the above two levers to switch gears? What happens to our BOP, a crucial Achilles heel in our economy? Does unsustainable foreign debt permit SBP to take the interest rate to a single digit in a matter of weeks?
Does the main characteristics of our monetary economy, i) highest cash to GDP ratio in the South Asian region (more than 50% as compared to 17% for India), ii) Large informal sector (around 77% in the last 20years), iii) underground economy, e.g., drug and human trafficking, smuggling, and iv) relatively high dependency on (formal/informal) foreign remittances, impact the effectiveness of interest rate cut on future consumption/investment decisions? An attempt will be made to analyze these questions in the following paras:
It is well established that major beneficiary of single digit interest rate in a downward cycle would be the state. With falling interest rate cycle, falling debt servicing on domestic debt, (a huge item of current expenditure) will spur a spending spree on grandiose unproductive infrastructure, popular freebies, relief mantra and retaining subsidies in the name of growth and development. Austerity ‘can’ will be kicked further down the road as nothing meaningful has happened in the last 4 months.
This spending party will be reinforced and continue till net surplus of PKR 1.7 trillion thanks to SBP profits are exhausted. Backward and forward linkages of government spending in the name of growth and investment will also spill over to the private sector in terms of higher demand and kickbacks.
Inflation is likely to be sticky with constrained domestic supply of cotton, vegetables, fruits (by April maybe wheat) and free export of sugar and meat. The axe will fall on BOP deficit via higher imports (Cotton) and reduction in rice exports due to opening of Indian market.
Moreover, IMF-backed increase in CNG rates (they may be delayed because of SBP bonanza) on the cards, although prices of petroleum products may move within a narrow range.
The industrialist lobby will cry out “Too little too late” as they wish for a fall of 400 points in one go. Even with a fall of 200 basis points hardcore productive export-inducing investment will remain a dream.
Why? a) there are alternate avenues of casino investment with less hassle, yielding better and faster returns than 15.5% (if SBP goes ahead with 200 basis points), b) The nature of huge investments in energy and minerals mostly involve G2G as they are laced with hidden subsidies and tax breaks, which the private sector cannot offer or are able to secure, c) Admittedly, although it needs to be verified empirically, the private sector may go for large-scale up-gradation of textile sector and/or agriculture processing sector if interest rates drop below 10 percent and is closer to 5 percent.
Moreover, massive scaling of food processing sector for exports is not possible as it is supply constrained due to climate and explosive population growth and remittances induced demand push, and c) Other sectors such as IT and engineering require innovative and skilled manpower which are on the run, also backed by G2G to promote their export for more easy and quick inflow of USD.
However, interest downward cycle will help the private sector in borrowing for import and stocking of raw materials, before the next cycle of upward march of exchange rate.
It will be the quick and high-return investments in casino economy which will continue to benefit mostly in downward cycle of interest rates rather investment for producing non-textile exports.
When half of GDP thrives on cash transactions, borrowing is ‘fungible’ in its use in-spite of banking regulations, and traders (nearly 25% of GDP) are averse to borrowing on socio-religious grounds, rather preferring ‘committees’ for stocking-up, it leaves the government and its SOEs as major clients for borrowed funds and limited interest rate effectiveness.
With car loans once again rising in the last quarter, buying of apartments/construction picking-up, stock market in dizzy heights, inspite of dull manufacturing sector, investment in manufacture/processing of consumption goods due to healthy flow of remittances, brisk demand for Gold, and USD losing its speculative shine one can guess how much productive investment took place in the previous downward adjustment of policy rate and how much it will benefit export-led investment vs other sectors of casino economy in the future downward adjustment of policy rate.
With explosive population growth, 39% growth in remittances, construction, buying cars, stock market and tax-free WRT sectors will provide far better returns even with borrowed funds at 15.5% complemented by a distorted multi-layered interest rate policy at the sector and individual level.
In conclusion, the dilemma for policy setters is what this downward and speedy cycle of rate setting will achieve? Do they want casino economy to be the driver of consumption-led inward growth or surplus generating export-led growth? Unfortunately, that dilemma also requires a vision instead of blindly following the inflation cycle.
Moreover, the trade-off between fiscal stabilization vs external sector stabilization is also apparent from the above discussion.
Copyright Business Recorder, 2024
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