No more tightening

The SBP Governor in a public gathering spoke about the interest rate determination. He was spot on to say that the objective of the interest rate is to arrest inflation. Hence, if the inflation in near future is likely to surge, the proactive approach is to raise interest rates today. Something SBP was not doing for many years, and the institution was reactive during 2016-18, and the cost was paid in terms of ballooning twin deficit.

The other element he rightly pointed out on the inflationary nature of government borrowing from the SBP i.e. monetization of the deficit. But the institution needs to see the subject in totality where the structural documentation issues has resulted in higher cash economy, and that has jacked up the SBP borrowing without even creating any deficit.

For example, if a deposit holder withdraws his money from a bank, the bank has to sell equivalent amount of T-Bills to the SBP for giving back money to the deposit holder, and that increases government borrowing from SBP without creating any deficit. Hence, without reducing the CIC to M2 ratio, the problem of deficit financing may not solve just by increasing interest rates.

The CIC to M2 ratio increased from its historic ratio - 22 percent in June 2015 to 28 percent in March 2018, after the imposition of tax on banking transaction on non-filers and other some other taxes on non-filers. (read "Doing away with the transaction tax", on 30th October 2018)

That practice is discouraged, and the expectations of documented economy to grow are increasing from now onwards. This may bring back the liquidity into the banking system to finance the government deficit without going to the SBP. An excess of Rs1 trillion is taken out of the system - higher from historic ratio, and if that money is attracted back in the system, the government reliance on SBP borrowing would reduce automatically.

At this point, banks bid at higher rates for government short term papers, and the government will accept all, in case of no borrowing from SBP. The market based interest rates will jack up further. The problem is that the system liquidity is limited and jacking interest rates will not be able to get all the required deficit financing.

The problem is twofold - contraction of NFA and expansion of CIC to M2 ratio. The NFA of the banking system shrunk from around Rs1 trillion (8% of M2) in June 2016 to minus Rs822 billion or -5 percent of M2. That has increased the reliance of government borrowing on domestic sources. But at the same time the money is persistently going out of the system - which is either kept in cash at home or sent abroad through grey channels.

Hiking the interest rates, without resolving the structural issue of documentation and money laundering, will increase the overall fiscal deficit of the government - owing to higher debt servicing cost. There is also the negative externality on growth of the productive sector where high financing cost would elude new projects or expansion by existing players.

The other problem is too much currency adjustment which brings inflation home, and the cost push factors cannot be dealt by curbing demand through jacking up interest rates. The economic growth is already slowed down to 3.3 percent and the government expects it to be at 2.4 percent in FY20 - the demand is already curbed and further tightening could have an adverse impact on poverty.

Bringing currency and interest rates to their respective equilibrium has been the call for quite some time. A 180 degree shift to excessive tightening could be counterproductive too. The currency is already under valued and real interest rates are at 3-4 percent. A better strategy is to slowdown the tightening and let the steps on documentation yield results.