Window dressing of balance sheet items around the reporting period is probably one of the few universal practices in modern-day business management. Management sets overly optimistic growth targets: sometimes growth remains tepid; on other occasions, targets may be achieved but still underperform competitors. Come the financial year close, the sales teams’ necks are on the line, and targets are chased like failure would bring the world down. Channel stuffing takes many forms, often via trade and merchant discounts or other means of attractive and mostly unsustainable pricing incentives. Whether you are in the FMCG industry, retail, or telcos; in developed markets like the US or weaker ones like Pakistan, window dressing is as much of a constant as sunrise and sunset. The boards know it, the shareholders condone it, and the regulators ignore it – at least until it is within the ambit of the law.

But probably nowhere is it as prevalent as in the banking and financial industry, where banks smash the preceding year’s record-breaking growth with yet another year of stellar performance. Beefing up the balance sheet may require mobilizing deposits at loss-yielding rates of return or pushing advances at less-than-market rates, only to shed those poor-earning assets (and liabilities) as quickly as they were booked once the reporting period closes. It’s like Sports Day at a kindergarten where everyone is a winner – and congratulates each other on a job well done.

Yet, it wouldn’t matter if its consequences weren’t truly profound. While commentators express their shock over how the ADR tax has broken the banks, with banks shedding – instead of chasing – deposits, maybe for the first time since their privatization, the truly dark side lies on the other side of balance sheets: the advances. Naturally, deposit chasing (or shedding) affects a higher number of banking customers than advances, especially in a country like Pakistan. However, it is the growth on the assets side that, in the long run, affects all consumers in the economy via the oldest trick in monetary books: more money chasing fewer goods.

Whether year-end deposits exit the banking system or stay isn’t directly inflationary because if banks keep them, they lower the money in circulation, but if they shed them, it represents funds that were already flowing in the economy before year-end. Either way, they are not the subject of discussion in this column.

Now look at the accompanying visual carefully. The x-axis represents year-end increases in advances during the preceding year, where the primary driver is window dressing. The y-axis indicates year-on-year increases in advances in the following year. The percentage next to the year’s label indicates the average discount (or policy) rate during the year.

Notice that the graph can be divided into two neatly divided clusters of data points. On the lower left-hand side are years when year-end advances’ increase (for window dressing) wasn’t too high – or lower than two percent. But interestingly, the rise in advances during the following year (on the y-axis) wasn’t too high either. On the other hand, the cluster on the top-right includes years where the higher rate of window dressing in the preceding year (three percent or higher) was followed by an above 10 percent increase in advances during the following year.

Correlation is not causation. It would be enormously stupid of the author to insist that year-end window dressing alone is the primary driver of credit growth. When interest rates are lower and the economy is in expansionary mode, credit growth is higher – and vice versa. However, notice that in the last twenty years, the correlation proves to be a more reliable forward-looking indicator than the policy rate during that year. For reference, notice that with a 16 percent 12-month average policy rate, CY22 is still in the top-right quadrant of high credit growth. Meanwhile, notice that CY15, with only a 7 percent 12-month average discount rate, is on the lower left.

Why? The exceptional years, in fact, help illustrate the point. While the price of credit – the interest rate – must always be the primary driver of credit growth, two additional forces blunt its impact. One is the well-documented and understood delays in monetary policy transmission. But second, and maybe more localized to the Pakistani context, is the staggered nature in which monetary policy settings are adjusted. First, not at all – and then suddenly, under market pressure – the benchmark rate is either driven too low too quickly or kept too high for too long.

As market players, banks are in the business of anticipating the direction of the monetary cycle. So, when banks begin to pump too much credit too quickly only to meet year-end targets, it is not just a temporary loan that would be settled come January. It is usually a foreboding of a growth cycle. Logic dictates that management targets and compensation incentives would demand a higher number come next year.

But importantly, when businesses borrow credit, it cannot just sit on their books accruing markup. Barring the unscrupulous practice of borrowing to park funds in money markets and mutual funds to earn a short-lived arbitrage, most businesses may, in fact, use the credit for working capital requirements. And here is the thing: once the funds enter the real economy, they cannot just be withdrawn – at least not until the economy enters a recession.

This is why the central bank should be wary of lowering the interest rates too quickly this time. What used to always begin with December has this time begun in October, thanks to the ADR tax anomaly. Month-on-month credit has increased by 16 percent, the highest since 2005 or since the records are available, and maybe the highest ever in history. Banks have pumped nearly Rs900 billion in credit only to private sector non-financial businesses, most of which will remain in the system for at least the year-end. Three months is too long a period for what would be trillion-plus rupees in the real economy, generating demand. This is at a time when the benchmark rate is still at 15 percent, and the monetary expansion cycle is yet to begin.

One would imagine that the central bank would be excessively cautious after the disastrous inflation of 2021-2023. Yet, it appears unaware that its missteps may already be lighting another fire.

Beware. Be very, very aware!