The latest meeting of SBP policy rate committee, also known as Monetary Policy Committee (MPC) in November once again decided to hold the policy rate at 13.25%, inspite of political and non-political (gurus, media and trade lobbies) pressure on SBP to lower the rate. It is apparent that SBP or its committee members did notsuccumb to this outside pressure and their final decision (split or unanimous) was data driven on the expected performance of the economy.In the September meeting only 1 member out of 9 was in favor of lowering policy rate (Who? remains a mystery). The minutes of the November MPC meeting are still keenly awaited.
Unlike the debates on inflation and poverty based on the point estimates generated by primary data, the debate in the MPC most likely hovered around synchronization of interest rates with expected inflation in the coming months (latter dependent on supply, demand factors and administrative prices), expected monetization of deficits, expected REER changes and sensitivity of investment and production costs. This article will dwell on sensitivity of investment and production costs to interest rates as this impact is currently politicizedin presence of sparse empirical investigation.Let me discuss how politicization of this impact suffers from generalization andcasual empiricism in case of Pakistan. From eco101, it is the gospel truth that investment is negatively related to interest rates and simple Keynesian extension leads to the conclusion that higher interest rates lower growth. A recent paper by researchers in COMSAT, using latest statistical techniques and Pakistan data from 1960-2017 reached a startlingconclusion that, "that there exists a unidirectional causal relationship from economic growth to interest rate". In other words, higher economic growth leads to higher interest rates. Rationalizing it, the authors state, "The second possible channel could be; given the supply side bottlenecks, an increase in growth lead to increase in inflation. In order to control inflation, the State Bank of Pakistan may increase interest rate". The economic rationale for explaining the current episode of high policy rates by the SBP is well known but in essence it is similar to the above explanation.
The stand of politicians and gurus is that in the second round of transmission, high interest rates are feeding into costpush inflation by raising production costs. It mayhave merit but in absence of quality data on what is the share of interest costs in production (After 15 years, the results of latest CMI are keenly awaited), it can be causal empiricism including the extent of contribution by supply side constraints, $ denominated administered prices, low labour productivity and inefficiency in productive sectors.
The relationship between interest rates and investment/production costs is too complex specifically and risky to generalize it to a single number in Pakistan as per the gospel truth of ECO 101. In addition, theobserved cycle of rising interest rates since August 2018 are accompanied by attempts aimed at increased documentation of the economy in presence of overall roller coaster political instability which may affect the after tax returns if implemented effectively. Thus to entirely blame the continued sluggishness of the economy on high interest rates and propagate that a faster decline in interest rates is the panacea for speeding GDP growthis a gross simplification. It requires strong empirical evidence that can isolate the impact of higher interest rates in stifling growth and its composition.
Investment, financial as well fixed (to increase the productive capacity of the economy) is undertaken by a) internally generated funds and b) obtaining loans from the banking system. Finance 101 tells us that it is profitable to borrow from the banks as long as the expected rate of return oninvestment (financial/fixed) is higher than the nominal rate of interest on borrowed funds. In a similar vein borrowing at high interest rates for working capital can reinforce cost push inflation depending on its volume, tenure and share in overall production costs. It is also to be noted that expected rate of inflation is one element that also influences the expected nominal rate of return on investments, specifically fixed investments.In a largely undocumented economy like ours the fungibility characteristics of loans taken by the private sector for working capital, exports financing (subsidized) and even to some extent fixed investment (via over invoicing of machinery imports) govern the relationship between interest rate,fixed and financial investment and GDP growth.The hypothesis that more a sector is poorly documented and lightly taxed, the higher is the incidence of fungibility and a) lower is the impact on productive capacity (real growth) or/and b) generates distorted/unsustainable impact on growth and its composition.
The following back of the envelope exercise on outstanding loans by the private sector (a soft proxy for demand for credit as outstanding loans may have component of accumulated interest accruals) in relation to policy interest rate may shed some light on this testable hypothesis.The above hypothesis is tested onoutstanding loans of 4 private sectors in terms of degree of poor documentation, low taxes and a prior higher incidence of fungibility. These are agriculture, textiles within manufacturing, construction/real estate and wholesale/retail trade (WRT). Two interest rate cycles are compared: i) Between July 2017 and June 2018, it hovered around 5.75 and 6.50 percent and ii) between July'18-Sept'19 the range was from 6.50-13.25 percent.
The first indicator is the share of the above two types of loans in total loans as well in total loans of each of the 4 sectors. The share of working capital loans in total outstanding loans fell marginally from 43.9in June'18 to 42.1 percent in Sept'19 respectively. For fixed investment the corresponding share in total outstanding loans are 33.7 and 36.1 percent. Roughly these two types of loans constitute 75-80 percent of total outstanding loans and are impacted by interest rate cycles.
The working capital loan share of above 4 sectors in their individual sectors' total outstanding loans in June 2018 was 70.4, 34.2, 40.2 and 64.3 percent. In Sept'2019, the shares of all these sectors fell to 65.8, 29.0, 25.4 and 58.3 percent. In cycle ii, the biggest fall was in construction/real estate followed by WRT. Under fixed investment, again the biggest fall was in construction/real estate. The proponents of interest rate cut would attribute this solely to rising interestrates. As per above hypothesis it is supporting the argument that the more a sector ispoorly documented, the more the opportunity to earn speculative returns/above normal returns by borrowing at low rates and diverting the working capital to financial investments such as foreign currency, empty plots, stock shares, mutual funds, informal saving, jewelry, speculative imports (due to anticipated devaluation), housing and automobile sector. Unfortunately these avenues to use working capital/fixed investment loans for earning unrecorded above normal profits have tightened due to closing of gap between high interest rates and speculative returns and drive for documentation.
Copyright Business Recorder, 2019
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