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Skyrocketing interest rate

The Pakistan’s economy is facing numerous challenges, which has impacted the overall economic activity. The economy is still and essentially bedeviled by large size and inefficient public sector, low rate of savings and investment, persistent large budget deficits, and inconsistent macroeconomic environment. All these factors have hampered the growth of the economy; yet country still remains hopeful to brighter days ahead that improvements in the exchange rate and interest rate management could make a difference to the economic growth efforts. One of the key elements which will impact the economy negatively is high interest rate with devastating impacts on the cost of borrowing and investment in Pakistan. Interest rates are crucial elements in the transmission of monetary policy actions to economic activities. The interest rate policy in Pakistan for example has changed within the time frame of regulated and deregulated regimes. However, the impact of this variable on the economic growth of Pakistan have remained controversial.

Interest rate was as low as 5 percent few years back and it has now risen to over 12 percent. State Bank of Pakistan (SBP) is using interest rates to control the inflation. SBP has increased policy rate by 150 bps to 12.25 percent effective from 21 May 2019 and next increase is expected in next few days. SBP says that despite narrowing, the current account deficit remains high, fiscal consolidation is slower than anticipated, and core inflation continues to rise therefore, it decided to increase the policy rate. The private sector is becoming increasingly averse to bank borrowing with successive interest rate hikes, a development that could further slowdown in the economy. The latest data for private sector credit offtake covers the period till June 30 shows a declining trend from last year. The latest data shows that the private sector is in fact retiring its debt instead of borrowing for investment.

SBP in the last monetary policy increased the interest rate to 12.25 percent from 6 percent in January last year, which is the fastest single-year increase in interest rates ever in Pakistan’s history. It seems that the cost of borrowing is so high that both borrowing and lending became risky. The 12.25 percent discount rate means the borrower would get money not less than 16 percent from the banks. Which business can survive at this interest rate. The rate is too risky for the lenders as the chances of default have increased, which means additional security for lenders from the borrowers, which means higher cost of arranging debt thus businesses would avoid expansion of their business and can curtain their operations as well, which means unemployment or less job creation and less tax collection.

Some economist believe that interest rates play a crucial role in the efficient allocation of resources aimed at facilitating growth and development of an economy and can be used as a demand management technique for achieving both internal and external balance with specific attention for deposit mobilization and credit creation thus enhancing economic development. Even though many expansionary monetary policies have been implemented, the inflationary pressure has increased and forced SBP to raise the interest rate. As a result, the interest rate raised has become controversial.

One of the key elements we should work on is to try to identify the impact of interest rate on the economic growth. The economy continues to deal with issues as interest rates and current account deficit, import export imbalance and high inflation, therefore, in short term it doesn’t seem possible to see downward trend in the interest rates, may be few basis points but certainly not significant drop even with new leadership at the SBP. Interest rate is expected to have either a positive or negative impact on the economic growth where, decreasing the interest rate due to expansionary monetary policy may stimulate the economy because of increased economic activities. On the other hand, slow economic growth which may be due to a tight monetary policy via a relatively high interest rate regime can lead to a fall in the economic growth. We are witnessing the later in Pakistan these days. Increase in interest rates are also reflected on the saving rate (national saving certificates), lending rate, and the discount rate. Interest rate in Pakistan over the years has played an important role as one of the instruments used by the SBP in managing Monetary Policy.

 

The behavior of interest rates is attributable to a number of factors including: a) the high rate of inflation arising from the huge fiscal deficit of federal government which was financed mainly by SBP; and b) using interest rate to block outflow of money in the form of foreign exchange and collection of large funds in the banks. The factors that influence saving decisions differ among individuals, first affecting factor is income. With higher income individual may save more, though the decision to save is determined not only by the level of income, but also by expectations about future income, and ability to consume and save and attitude of the individual itself. Moreover, these preferences may change after change in the level of income. Another factor affecting the level of savings is compensation obtained by someone for lending his saving to another person, who needs additional funds and ready to pay for their use. This means, depositing in the bank and allowing banks to use the depositor money for lending to its customers. The compensation or payment for use of funds is interest rate. The more the interest rate, the more individual’s opportunity costs of consumption, and the more he will save. The total savings in the economy is a sum of all individuals’ savings; this is how SBP intends to control inflation of the country by controlling spending.

The cost of funds for borrowers is interest rate. The more the interest rate, the fewer borrowers will invest, so investments are a negative function of interest rate. Borrowers will be willing to invest as long as marginal benefit from investments equals marginal cost, or interest rate. Total demand for investment in the economy is determined as the sum of individual demands. It is safe to say that interest rate has an impact on growth; the growth can be improved by lower the interest rate which will increase the investment.

SBP should set interest rate policies that will boost the economic growth. Therefore, proper measure should be taken in order to have a more rapid economic growth. Growth will automatically bring in the stability in Rupee value, will also create jobs and will also bring down the inflation. Focus should be on the growth. We have examples of past as current economic situation is not first of its kind in Pakistan. There are many studies, reports and findings in past on similar crisis, read those documents instead of reinventing the wheel, no shame or harm in using past documents to bring stability in the economic condition of the country. Most of the times, we stuck in our ego of being superior and shy away from acknowledging others intelligence, just remember we will be remembered by the final results we have produced and not how we reached to that point.

Moreover, it is also recommended that a) the policy makers and authorities should carry out reforms that would enhance the role of interest rate in order to mobilize funds for investment purpose; b) in order to have a more rapid economic growth, country should lower the interest rate so that the investment will increase; c) the policy direction of interest rate, investment must be seen, not only in the context of price and financial stability but also in improving development in Pakistan.

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