Sometimes it doesn't pay to be overcautious

The discount rate was further reduced by 100 basis points to 8 percent on 15 May 2020 - the fifth reduction in less than two months. The discount rate was 13.25 percent from 20 July 2019 to 16 March 2020, 12.50 percent from 17 March to 23 March, 11 percent effective 24 March to 15 April 2020 and 9 percent from 16 April till 14 May. And with respect to a steady decline in the discount rate post-Covid-19 taken by the Monetary Policy Committee (MPC) under the chairmanship of Governor State Bank of Pakistan (SBP) Dr Reza Baqir, the consensus amongst former SBP governors, economists and industrialists was that although the decision reflected a correct trend, it was not enough.

The major responsibility of a central bank is to check inflation. Pakistan's core inflation was 6.4 percent while headline inflation was 8.5 percent in April 2020. Before Dr Reza was appointed Governor SBP on 6 May 2019, the discount rate was linked not to headline but to core inflation, supported by all previous SBP governors, as denoted by a SBP research paper uploaded on its website, and economists. The reason: headline inflation includes components that are not susceptible to the prevailing discount rate particularly prices of petroleum and products and energy in marked contrast to core inflation. The May MPC continued linking the discount rate with headline inflation by stating that "the government has significantly reduced petrol and diesel prices by 30-40 percent in response to the continued fall in global prices which has improved the outlook for inflation...the MPC noted the significant reduction in headline inflation since January on the back of sharply decelerating food and energy prices as well as easing core inflation. Looking ahead this waning price momentum is expected to be complemented by the recent 30-40 percent cut in domestic petrol and diesel prices creating room for today's additional rate cut." This may therefore be the reason that the size of the rate reduction has found few takers. However, when viewed in the context of the negative effect that the discount rate reduction has on the rupee (PKR) because of our vulnerabilities, it is not difficult to understand the SBP's strategy of moving with utmost caution.

In this context, it is relevant to note that the IMF's Extended Fund Facility (EFF) programme documents for Pakistan projected an inflation rate for the current year at 13 percent which provided the rationale for the 13.25 percent discount rate from 20 July 2019 till the onslaught of the pandemic. IMF document 'request for purchase of the rapid financing instrument (RFI) staff report' dated April 2019 supports the cut in policy rate to 11 percent to "prevent disorderly market conditions" that allowed the exchange rate to act as a shock absorber accommodating an 8 percent depreciation (27 February to 9 April 2020) of the exchange rate versus the dollar yet warned that "with inflation still in the double digits...the need (is) to remain vigilant of potential inflationary pressure arising from the rupee depreciation and supply side pressures." The rupee has since strengthened and stabilised that may have prompted the IMF's second cautionary statement: "staff stressed that interventions in the foreign exchange market should remain limited to prevent disorderly market conditions."

Be that as it may, given the uncertainty of the duration and the actual impact of the pandemic on the economy the IMF is unlikely to take exception to recent rate cuts based on the demand for resources by the government to mitigate the impact of the pandemic on the general public as long as policy decisions to provide relief are targeted and temporary.

A high discount rate attracts hot money, an undesirable form of foreign inflows, which may leave the country at a moment's notice and this was in evidence as the pandemic spread globally, including our major trade partners that led to cancellation or delays of export orders, and large-scale lay-offs of Pakistani workers employed in the Gulf lending credence to IMF's projection of remittances lower by 5 billion dollars than was projected. Pakistan too witnessed an outflow of over 2 billion dollars as the discount rate was lowered and perhaps this is also one of the reasons for the staggered reduction in the discount rate given the five readjustments since 17 March to bring it to the current 8 percent.

The contractionary monetary and fiscal policies as per the IMF's EFF design had already begun to negatively impact on growth particularly of the productive sectors - a trend that has exacerbated manifold with the pandemic. The reduction in the rate is unlikely to act as a lure for the private sector though the government will without doubt be able to avail the direly needed fiscal space thus created.