State Bank of Pakistan (SBP) is in a monetary tightening phase raising discount rates continuously for the last few months but persistent demand pressure in the economy is forcing it to add certain basis points in this quarter as well. Central bank is taking certain corrective measures to prevent the economy from high inflation, growing circulation of money and probable decline in the growth rate in fiscal year 2018-19. Recent Monetary Policy Statement recognizes that it has missed the current fiscal year’s target of money supply growth due to current account deficit and various other foreign exchange challenges.
The State Bank of Pakistan on March end increased the policy rate (interest) by 50 bps to 10.75 percent, which will be applied from April 1. Average headline Consumer Price Index (CPI) inflation reached 6.5 percent in July-February of fiscal year 2018-19 compared to 3.8 percent recorded in the same period last year. Meanwhile, year on year CPI inflation has risen considerably to 7.2 percent in January 2019 and further to 8.2 percent in February 2019-the highest year on year increase in inflation since June 2014. These pressures on headline inflation are explained by adjustments in the administered prices of electricity and gas, significant increase in perishable food prices, and the continued unfolding impact of exchange rate depreciation. Core inflation maintained its 13-month upward trajectory accelerating to 8.8 percent in February 2019 from 5.2 percent a year earlier. The fiscal deficit for the first half of fiscal year 2018-19 was higher at 2.7 percent of GDP when compared with 2.3 percent for the same period last year. The government has borrowed Rs 3.3 trillion from SBP and retired Rs 2.2 trillion of its borrowing from scheduled banks (on cash basis) during 1st July to 15th March of fiscal year 2018-19.
Banks are currently facing liquidity crunch because of the outcome of the central bank’s policy to keep the market dry in fear of inflationary pressure coming out from the outflows of dollars. Most of the loans and advances of scheduled banks are in three sectors i.e. agricultural, industrial and export, which showed a mixed trend after the hike of interest rates. Whereas most of the sectors are reluctant in getting fresh credit lines due to increase in the financing cost. State Bank is attempting to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country’s national debt.
In recent months, SBP has taken certain steps in open market operations where it buys or sells T-bills in the open market. Few years back, SBP’s intention was to expand the money supply where it bought from the open market and lowered the discount rates and KIBOR. With the growth in the economy in last years and rise in the money circulation, SBP now intends to block the supply of money, for this, it is selling T-bills in the open market and is increasing discount rates gradually. This is most widely used instrument by SBP in day to day control of the money supply because of its ease of use and relatively smooth interaction it has with the economy as a whole. Another option which SBP has and exercises quite often is Discount Window. SBP offers funds to the commercial banks, and other depository institutions at a discount rate. This rate is usually set below KIBOR. Therefore, by affecting the money supply, monetary policy establishes the ranges for inflation, unemployment, interest rates, and economic growth.
As the inflationary pressure is constantly building, the State Bank is raising interest rates regularly in an effort to keep the pace of economic growth consistent, which is the biggest challenge of this government. Typically, higher borrowing costs slow the economy by forcing consumers and businesses to cut back on spending and investment. But the impacts of rising interest rates affect different groups in different ways. The SBP changes the economy by buying and selling T-bills to manipulate the discount rates whereas banks charge interest rate to each other for the overnight loans. When the discount rate rises, other interest rates tend to follow as lenders seek out the highest returns. For example, when the SBP raised its benchmark rate by a fifty basis point, banks increased the KIBOR (the price of borrowing for their customers) by an identical amount. Like KIBOR, other interest rates are also linked to the SBP discount rate, but not always as tightly. Factors like the level of government borrowing and future inflation expectations effect the direction of interest rates.
It is also important to recognize the side effects of monetary policy tightening. Various circles have raised concerns on the increase in discount rates in recent quarters. Apparently SBP intends to slow economic activity to stop inflationary pressures from building. It is evident that inflationary pressures have been building since last few months but particularly since November 2018. Despite all measures, it appears that level of satisfaction is far away. It was expected that the rate increase which have already occurred is likely to have a large impact on the level of business activity. Both food and non-food inflation are increasing. It is vital to note that prices of almost all the consumer products have increased recently which in coming days will again get additional rise especially governments recent decision to increase the fuel prices. Ramazan is about to start and it is being said that inflation would be highest in recent years in this Ramazan. The debt servicing of the federal government is also continuously increasing. A major reason attributed by industry for this slowdown in industrial activity is an increase in the interest rates. Therefore, higher interest rates are also hampering the financial position of the exporters and business houses. It must not forget that due to this, Pakistani goods may not compete globally.
The effect of interest rate adjustments are notoriously difficult to gauge in advance. Neither the strength of the impact nor when the impact will be at its peak can be determined with any certainty. What can, however, be said is that the Pakistan’s economy is now entering into an unknown territory. It is facing many challenges for instance, interest rates have been raised, the economy is not growing at all, dollar is appreciating against rupee, and top of that no clear economic road map. Therefore, it is hard to think of a positive role for interest rates in the presence of these issues. It is expected that the Pakistani products will be further non-competitive globally in coming days. Anyhow, most economists believe that it is a necessity to fix the inflation first while interest rates could again be lowered as soon as the goal of price stability is achieved.