The State Bank of Pakistan (SBP) has cut its Discount Rate by 50bps to 9 percent, but has not cut its Reverse Repo and Repo rates implying that the rates at which banks can either borrow from the SBP or place with it their surplus liquidity remain unchanged. SBP's justification for the cut in its discount rate is a combination of softening trends in inflation, business and industry's rising confidence (as reflected in a rise in private sector credit) for reviving the economy, and the need for reducing the cost of doing business. On their own, these are sound objectives given Pakistan's present economic state, but not so when one looks at the other ground realities, the biggest of them being the disparity between increase in money in circulation and the GDP growth rate in the past three years. Until June 7 this year, money supply expanded by 12 percent compared to 11 percent in the same period last year.
Extrapolation of the level of money supply as of June 7, 2013 and June 8, 2012 suggests that, as a whole, in 2012-13, money supply would exceed 15 percent. Prudence demands that money supply increase should be only slightly higher than the rate of inflation to sustain the interest for expanding business activity in the hope of moderately higher returns, courtesy only marginal rise in money supply over GDP growth. But, compared to a 15 percent rise in money in circulation, GDP growth has been only 3.6 percent. This is the scenario that places in doubt the estimates of headline, core, and consumer inflation indices, a sustained decline in which has been used to justify the discount rate cut. Simple mathematics, not ingenuity, can help understand how inflationary would be the impact of such a huge increase in money supply (currency note printing?) compared to the low growth in production of goods and services whose sum total is represented by the GDP. Besides, if the inflation figures are indeed correct (meaning thereby that savers were actually getting a positive real rate of return), savings should have increased substantially-an outcome that didn't materialise. Seemingly, inflation was higher than its officially announced indices. Despite a cumulative rate cut of 450bps since June 2011 until June 20, 2013 private sector borrowing remained subdued; the key driver of monetary expansion and reserve money growth was government borrowing from the banking system and the SBP. By implication, the government was the main beneficiary of the rate cuts. The bigger harm done to the economy was that continued slide in the discount rate brought down profit rates on savings and the savings-to-GDP ratio did not rise - a rise Pakistan badly needed. At the same time, the monetary policy admitted that the real challenge continues to emanate from lack of financial inflows and higher external outflows, given the load of ongoing repayments to the IMF. This clearly pointed to the need for mobilising domestic resources. The question is: can lower returns on savings induce higher savings and lower consumption to cut deficits of all kinds, especially the trade and consequent current account deficits? Only the SBP Board of Directors can reply convincingly to this key question. In its report on the third quarter of 2012-13, the SBP had rightly conveyed a clear message to the government-far higher need for savings that could fund not only the private sector credit but also the fiscal deficit, but using tools that didn't slowdown the economy. The SBP had suggested that "as a strategy to reduce domestic debt-servicing burden, the government should move away from bank borrowing, which is both short-term and costly." The alternative suggested by the SBP was domestic non-bank long-term borrowing. The advice implied that the government should opt for domestic borrowing via PIBs. It seems that, to help the government in borrowing long-term at substantially lower cost, the SBP Discount Rate has been lowered on a sustained basis using a variety of justifications. Indeed businesses would like to cut their costs, one of them being the cost of borrowing, especially because most businesses continue to be under-capitalised and hence needing disproportionately large credit facilities, but more than that they need security.
Businesses are packing up not so much because of high cost of credit but because of social chaos, lawlessness, and power loadshedding. Using the suspect decline in inflation therefore sounds more like an excuse for lowering the cost of fiscal borrowing, much less anything else. About the balance of payment deficit the policy isn't clear when it says that, at around 1percent of the GDP it is manageable and signifies "very low but real" challenge that continues to emanate from the lack of financial inflows, given the load of ongoing payments of IMF loans. SBP admits that the pressure on foreign exchange reserves has not abated, and indirectly asks the government to seek sizeable long-term foreign funding. This too is an admission of lack of resources but this case SBP's preferred lender, most probably, would be the IMF. The SBP is right in advising the government to borrow on long-term, which implies availability of substantial long-term savings, but in the context of Pakistan, will its strategy work? The fact is that savings growth has been sliding - a fact admitted by both SBP and the government. We need yardstick interest rates that offer a positive (ie fractionally higher than the CPI) real return to the savers to build savings that are enough to fund the state and the private sector, and both must strive to bring down inflation to lower the yardstick rates. The monetary policy doesn't build this rational environment by admitting that the rate cut may prove inadvisable after the announced increase of one percent in GST, changes in tax structures for other goods and services, and withdrawal of subsidies to power tariffs. All of these changes will fuel inflation which, supposedly, has been on the decline. Then why cut the discount rate? Shouldn't the return on savings in rupees be made sufficiently attractive to discourage speculative demands for the dollar that is steadily appreciating against the rupee? SBP rightly fears a rise in inflation soon and the need to push up the discount rate again. Some commentators therefore explain the reason for its discount rate cut now as a helping hand in borrowing the Rs 500bn needed by the government to settle the circular debt by mid-August. If this explanation is fact-based, it doesn't reflect well on the way the SBP is manifesting its autonomy. It should be doing what is best for the economy, not political interests.