Policy rate hike

Monetary policy is one of the ways through which every country seeks to control its economy. If the money supply grows too fast, the rate of inflation will increase; if the growth of the money supply is slowed too much, then economic growth may face a slowdown. As widely expected, the State Bank again raised its discount rate by 50 basis points or 0.5 percent to 10 percent in its Monetary Policy Decision announced on 13th November. The new rate is effective from today. Justifying the hike, the State Bank said that "an increase in inflation while keeping the market interest rates at the current level can increase the incentive for borrowings and discourage savings in the economy. This can potentially increase demand pressure through consumption as well as dampen investment, and thus the productive capacity of the economy. In addition, with fragile external flows, negative real rate of return can encourage outflow of foreign exchange increasing the pressure on the exchange rate". Clearly, the central bank has premised its decision to hike the interest rate on the rise in inflation and weakening of current account balance, leading to a drop in reserves and erosion in the exchange rate of the Pak rupee. The revision in power tariffs, according to the State Bank, was expected to curtail subsidies and create fiscal space for other expenditures but such fiscal consolidation measures have their inflationary consequences. Adjustments in administered prices are directly reflected in higher inflation, as was evident from the current trends in CPI inflation. With continuance of these trends, CPI inflation is likely to remain at an elevated level ranging between 10.5 and 11.5 percent during FY14. The current account had a deficit of dollar 1.2 billion in the first quarter of 2013-14 due mainly to imports picking up at a relatively higher pace than exports leading to widening of trade deficit. Moreover, the financial account balance had a net outflow of dollar 68 million. Taking into account substantial repayments to the IMF, foreign exchange reserves with the SBP declined by dollar 1.3 billion during July-September, 2013 and their level dropped to dollar 4.2 billion as of 1st November, 2013. Speculative sentiment on account of IMF 30th September, 2013 targets added to exchange rate volatility. Progress on reforms and successful completion of structural benchmarks under the IMF programme could ensure additional financial inflows from other IFIs and play a critical role in improving the balance of payments position. In the absence of such reforms, the burden of adjustment falls disproportionately higher on exchange and interest rates that perpetuate speculative sentiment in the market.
In its Monetary Policy Decision, the State Bank has also devoted, as usual, considerable space to the needed fiscal reforms. It says that "carrying out reforms, particularly related to fiscal consolidation, are critical for the economy". Expanding the base for direct taxes and rationalising their rates were crucial for sustainable expansion of revenue collection. However, bringing the informal sector into the tax net was an arduous task. Fiscal deficit may be slightly higher than the budgeted 6.3 percent this year but would be significantly lower than 8 percent during FY13. However, the decline in the FY14 budget deficit would be mainly due to realisation of non-tax revenues such as the Coalition Support Fund (CSF) which are either one-off receipts or may not be relied upon on a long-term basis. As if to give some confidence to various stakeholders about the state of economy, the State Bank has, nonetheless, observed that "the fundamentals of the economy going forward in the backdrop of the recent policy and reform measures appear stable" and "the prospects of an economic revival inspired by successful political transition and the resolution of energy related circular debt issue are encouraging".
We feel that there was nothing unexpected in the bi-monthly monetary policy decision this time. Based on the latest inflationary trends in the economy and current account deficit of the country, almost all analysts were of the view that State Bank has no other policy alternative other than raising the policy rate though the extent of increase was a matter of some contention. Financial institutions were so certain about the tightening of monetary policy that in the latest T-bills auction, there was little appetite for government papers of longer tenors as the market was pricing in an interest rate hike. Moreover, keeping in view the deteriorating position in the external sector accounts, the central bank had to make the investment in rupee balances more attractive in order to stop dollarisation of the economy and stop the flight of capital from the country. A snapshot of interest rates in the region reveals that Pakistan's real interest rate was below one percent compared to almost one percent in India and 1.15 percent in Indonesia. With higher country risk associated with Pakistan, both local and foreign investors have to be offered higher real returns to encourage them to maintain their rupee balances in the country. More worrying is the expectation that falling foreign exchange reserves, rupee depreciation and double-digit inflation estimated during the current fiscal year would continue to be major factors in forcing the State Bank to maintain a tight monetary stance. It could, however, be argued whether the State Bank should increase the policy rate in one go or do it in instalments. The proponents of discount rate hike in one go, defend this policy approach on the basis of curbing dollarisation of the economy now underway, encouraging investors to keep their savings in Pak rupee and incentivising financial institutions and other savers to invest in longer term papers which would help in debt management. On the other hand, those who believe in increasing the policy rate in small increments argue on the basis of making the adjustment less painful for borrowers and allowing the central bank to act according to the evolving money market situation. Anyhow, the business community in general would continue to complain against the rise in interest rates for obvious reasons. Industrial activity in the country is already adversely affected by acute energy shortages, militancy and uncertainty about country's economic and fiscal policies. An increase in the lending rates would obviously affect their cost of production further and could render their products uncompetitive in the international market. An objective analysis would, nonetheless, reveal that productive activities in the country at this juncture are much more impeded by other constraints than tightening of monetary policy.
Another profound challenge for the State Bank is the continued expansionary fiscal policy of the government which forces the State Bank to raise the discount rate periodically and reduces the flow of credit to the private sector. That is why the SBP continues to harp on this particular theme but with little or no success. The behaviour of public sector enterprises (PSEs) has also become insensitive to the changes in interest rates. Against this backdrop and keeping in view the terms agreed with the IMF under its Extended Fund Facility (EFF), the present government had vowed to reduce subsidies, restructure or privatise PSEs, mobilise higher level of revenues through a variety of reform measures and economise on expenditure, but experience in the last few months shows that fiscal consolidation is easier said than done and there are obstacles and resistance at every step. It is unfortunate though that even the so-called governments flaunting strong electoral mandate yield easily to pressures from various lobbies for political reasons. We are afraid that if the present trend continues, the EFF may be derailed and monetary policy will fully become hostage to an expansionary fiscal policy with undesirable consequences on country's economy. In our view, both the government and the opposition parties need to be very responsible in this particular area and should urgently spread the message that bitter pills have to be swallowed by all and sundry for better fiscal and monetary management of economy and further erosion of country's political sovereignty. Last but not least, the government must not lose sight of the fact that the SBP can best function by remaining fully autonomous or independent from fiscal policy and therefore uninfluenced by the political concerns of any government. The government is also required to fully appreciate the fact that the absence of fiscal prudence in our policy narrative would mean that structural reforms would have to be undertaken without anaesthesia increasing the pain that must be endured in a dignified manner.