The SBP (State Bank of Pakistan) is trying to check inflation through just one instrument, the interest rate, based on the theological belief that the issue is demand, ignoring other, more critical factors, fuelling inflation today. There are both demand-pull and cost-push factors influencing inflation, and this instrument is being expected to achieve multiple objectives.

The sources of demand in the economy are households, corporate sector and government, who in turn receive money from different sources.

The role of each source and what can be done about it is somewhat limited, especially because the acts of one can nullify the actions of others, at times as a result of unanticipated developments. For example, when the SBP increases the interest rate it expects a change in behaviour of the borrower.

However, if the largest borrower, the government, whose imprudent and reckless fiscal behavior has worsened the precariousness of our situation, simply continues borrowing to finance expenditures which (except on development projects)are politically inelastic in the short to medium term and are more than its revenues it negates the objective of raising the interest-rate.

And the possibility of a change in behavior is further diluted, if not rendered irrelevant, if the net cost of borrowing is a mere 50 to 60 basis points because of the Rs.6 trillion injections of the SBP (lendings to the commercial banks which they then on-lend to the Federal Government).

Today it is the government driving aggregate demand (contributing to almost 90% all of the investments/lendings of the banking sector so far this year), whose fiscal ill-discipline is neutralizing the objectives of the monetary policy instrument, necessitating, therefore, adjustments/tightening on the fiscal side.

Then there are inflows of remittances and donor financial assistance which create a demand for goods and services that render policy instruments for containing demand largely redundant.

For example, annual remittances of close to Rs.14 trillion-20% of GDP-(both through the formal financial sector and through informal channels-money changers and migrants bringing cash on home visits), generate a demand for goods and services.

And these demands are more or less impervious to interest rates, partly because the recipients are less affluent households, dependent on these flows for meeting their regular basic consumption needs.

Again, SBP’s own sponsored export finance and long-term directed credit schemes (the more recent one being the TERF) at highly concessional rates of interest (although the rates for some schemes are now being revised) “create money”, diluting the influence of its monetary policy instruments to control inflation.

And then, not to forget, we have anominously large informal sector that conducts transactions mostly in cash (currency-in-circulation is presently in excess of Rs.8.5 trillion (more than 12.5% of GDP), on which adjustments in interest rates would have limited impact.

Furthermore, the effectiveness of SBP’s policy to ‘target’ some rate/range of inflation is also constrained by the structural nature of the problems. This monetary policy instrument also has other limitations.

For example, other than cost-push factors (see below) an increase in the interest rate cannot fight imported or food inflation when the latter is high because a) the support price of wheat is above its international price; b) increases in price of energy and oil raise the cost of farming, processing and transportation; c) yields per acre of crops’ continue to be low; and hoarding and cartelization (see below).

The cost-push factors affecting large areas of the economy result from:

• Rigidities in prices administered by government (e.g. of electricity, gas, petroleum products, etc.)-which have been revised sharply in recent weeks;

• Continuing supply chain issues driven more by the somewhat arbitrary import restrictions imposed by the SBP and price stickiness (despite the easing of supply disruptions post pandemic), creating opportunities for profiteering;

• A convoluted and badly designed tax structure that is heavily dependent on high rates of GST and other indirect taxes as revenue collecting instruments and mechanisms;

• Heightened inflationary expectations owing to eroding business confidence because of continuing political instability, policy confusion and concerns pertaining to the restoration of the IMF program;

• Hefty volumes of informal trade/smuggling under the active patronage of state functionaries;

• A host of powerful hoarders and organized cartels manipulating prices - like those of the sugar, vegetable oil, wheat, fertilizer and cement manufacturers;

• Poor economic governance adding to costs; and

• Continuing poor productivity (failure to get higher output from existing resources) of both public and private investments and operations and government investments in un-productive schemes that have stalled.

Increasing interest rates is not the remedy for revisions in government administered prices (unless the inflation target is adjusted for the effect of these prices) or for inflation fed by rupee depreciation and rising food prices.

And these prices are not affected by the weakening in demand for goods and services and the profligacy of government, as argued above, that keeps level of budget deficits high-whose financing then induces a raise in the interest rate on borrowings.

This worsens the situation, impairing the manufacturing sector, by crowding out the private sector seeking funds for even working capital, let alone for investment. In fact, this heavy reliance on high interest rates is merely protecting the incomes of banks and creditors from the injuries of inflation being suffered by the general populace.

Furthermore, as implied above, simply pursuing single mindedly the goal of checking inflation through the instrument of the interest rate adversely impacts growth and employment creation. And SBP, confronting government expenditures run wild, does not have an adequate set of policy instruments in its armour to stimulate growth, lower the rate of inflation and ensure stability of the exchange rate, all at the same time.

Lest we forget, inflation targeting has not been adopted as the sole objective by all central banks? The central banks of two economic power houses, China and the USA, do not merely target inflation-both inflation and employment are an integral part of their mandates.

Furthermore, the stubbornness of a high rate of inflation in a relatively depressed economy translating into a wage-price spiral would be remote if the rate of economic growth is lower than the rate of increase in the labour force.

Although, a variety of import curbing policies and instruments have been adopted, the Pak rupee is supposedly ‘free floating’ when it comes to trade in goods and services as well as on the ‘capital account’ (although ostensibly only for non-residents).

This means that we need capital inflows and donor support to maintain foreign exchange reserves in tradable currencies to enable us to face any crisis in financing external obligations. And any restriction on bringing in, and repatriating, capital will make the external investors reluctant to bring in this money.

But then reliance on inflows of borrowed capital on a continuing basis is clearly not sustainable, as we found out to our cost when we incentivized short-term foreign portfolio investments in the government’s debt instruments by jacking up interest rates.

This strategy, apart from temporarily appreciating the exchange rate, worsened the adverse movement in the domestic business cycle, by discouraging domestic investment. This “hot money” beat a hasty retreat at the first sign of weakness, feeding the already stressed conditions with respect to external payments.

However, despite the fragile economic environment we have opted to further raise the interest rate, partly to again solicit short-term external capital inflows for managing the external crises. This intervention is more than likely to fail because we are confronted with a solvency issue and not a financing/liquidity issue.

More borrowings to raise foreign exchange reserves, to discharge existing debt obligations and to finance our trade deficits will merely lead to a higher level, and more difficult to service, debt, in an economy that is fast shutting down.

To summarize the discussion above:

a) The dominant demand side factors, and economically relevant for the inflation checking objective of SBP’s monetary policy, whose behavior is not meaningfully guided or influenced by the revisions in the interest rate are: i) the high level of, and burgeoning, fiscal deficit, ii) remittances, and iii) the large informal/tax-evading sectors which carries out its transactions in cash.

b) The rest being cost-push factors, trade-related barriers (SBP’s administratively managed import restrictions) and hoarding and cartelization are also not notably affected by changes in the interest rate.

But then is one arguing that SBP has no role to play in the prevailing situation and high, and floating, interest rates have no relevance whatsoever? For instance, do interest rates sharply below the rate of inflation have no impact on the level of savings in an inflationary environment and on inflationary expectations? Won’t they incentivize switching of portfolios (to gold or dollars)? Or create asset bubbles (trade in equities, real estate/land) instead of productive investments? I proceed to address these questions below:

Our experience, supported by data over long periods reveals that Pakistan’s level of savings (ignoring for the moment the methodological issue of how they are estimated) has essentially remained the same, and at best there is a switching within this portfolio.

As for the importance of interest rates on expectations in a highly inflationary environment, even the SBP has not presented credible evidence on the driver of inflationary expectations? What is the anchor that tempers these expectations?

Can a negative real interest rate create asset bubbles? What bubbles can it create when it comes to the equities market in which there are less than 25,000 active traders? As for investment in land as a hedge against inflation, laundering of money through investments in land is becoming more difficult, although still not a huge constraint. However, the incentive to invest in land has been significantly diluted by the tax imposed by FBR on “deemed income” from vacant land.

Next, can a negative real interest rate lead to switching of portfolios — gold or dollars — as a hedge? Yes, logically it should, and is doing so, but, in this writer’s opinion, this will transpire not because a negative real interest rate will result in funds moving out of the banking/financial system.

Considering the a) extent of political instability, b) worryingly uncertain economic and policy conditions, c) size of the informal/undocumented sector (with its rapid growth in recent years) and d) massive amplification in the share of tax-evaded money, these “savings” are not likely to flow into the documented formal part of the economy-the banking system. And for all these reasons there is switching taking place, into dollars and gold in lockers (and other safe and secure mechanisms) along with, in many a case, capital flight to Dubai.

Finally, a decent chunk of the industrial sector is struggling to maintain commercial operations while remaining competitive and profitable (for the variety of reasons listed above — for instance, for money borrowed under TERF the plant and machinery has either not arrived or the SBP import related administrative restrictions do not allow the discharge of these obligations to the suppliers) while the loan has to be serviced.

Servicing debt at these interest rates or for reasons referred to above will be highly challenging, potentially leading to a gargantuan growth in the NPLs (non-performing loans) of banks, creating a crisis in the banking/financial sector, with all its implications for the rest of the economy and attempts to revive it.

So, in the light of the discussion above, what are the options available in the short to medium term to wrestle with the ravages of inflation? In this writer’s opinion, most of the adjustments need to be made are related to fiscal and governance issues, which are recommended below.

• It has been shown that several factors make inflation handling difficult. For instance, addressing food inflation requires a comprehensive policy package comprising policies that a) incentivize change in cropping patterns and increase in yields and cost efficiencies in production processes (a medium term strategy); BUT b) in the near term the first best choice is to opening up of trade with our neighbours; thereby also collaring the issue of informal trade/smuggling; and supplement this policy action by i) withdrawing import duties on Solar Tube wells; ii) lowering the duties and petroleum levy on high speed diesel while raising these charges on petrol by the same amount; and ii) as argued below, forcing fertilizer manufacturers to reduce the price of urea.

• Counter price gouging by cartels by not just opening up trade but also drastically reducing, if not eliminating, import taxes, thereby forcing cartel formulators to change behavior. Just as illustrations take the cases of the cement and fertilizer industries. The cement industry is operating below 60% capacity and selling cement at a margin of 26% (because of the eligible depreciation allowances for tax purposes and the cartel enabling it to raise prices whenever there is a pressure on costs).

Similarly, the fertilizer industry, thanks to an extremely generous gas subsidy is earning a gross margin of more than 35% with a net profit margin of more than 23%-compared with Apple’s 22%, with its market power, productivity and efficiency! With these levels of returns, essentially because of subsidies, the domestic price of fertilizer should be subjected to further, more effective, controls by a more vigilant government or the Competition Commission;

• Check government expenditures by a) starting to shrink the size of the Federal Government by reducing the number of Divisions to one-third (placing personnel in a surplus pool-saving on rents, utilities, cars, etc.,) and banning all new recruitments, purchase of motor cars and new development schemes; b) reviewing the PSDP (public sector development plan) to identify low priority projects or those on which less than 20% expenditure has been incurred and should be shelved and intra provincial projects to be transferred to the respective provinces for them to decide their adoption;

• Employ a combination of increased load-shedding and early closure of commercial centres;

• The short-term solution of enhancing the scale of programs like BISP (Benazir Income Support Programme) and Ehsaas, to provide some relief to those in extreme pain-hovering below or on the poverty line-although required, is clearly not sustainable. They cannot be an alternative and replacement of a more comprehensive and self-sustaining growth process;

• As argued above, lower the interest rate (making the real rate negative), bringing it below even the core inflation rate-there may even be a need for a two-year suspension on the servicing of both government and private sector debt;

• The continued servicing of the existing IPP (independent power producer) contracts are unsustainable. They need to be renegotiated speedily (rates of return, capacity charges and currency). And these efforts need to be complemented by adequate and timely investments to attend to the technical inefficiencies and governance issues of the transmission and distribution systems; and

• Finally, but more importantly, defuse the debilitating effect of political and economic instability by holding early elections to place in office a government with the legitimacy to launch, and implement, such actions.

Copyright Business Recorder, 2023