More annoying is the fact that the banks are not extending trickle-down benefit to depositors from their soaring profits.

SHAMIM AHMED RIZVI, Bureau Chief, Islamabad
Dec 04 - Dec 10, 2006

The Senate Standing Committee on Finance, in its meeting last week, expressed serious concern over the existing high rates of interest on loans that have multiplied the cost of doing business, besides causing damage to the industry and exports.

Swelling interest rates have raised profitability of the banking sector in the country and attracted leading international banks towards either acquiring or merging with banks in Pakistan or planning to launch their operations here. However, due to this factor, the profitability of the textile sector dipped in the first quarter of the current financial year by registering a negative growth of 14 percent. Besides, the rising cost of financing has subsequently pushed up the cost of production. There is also an unimaginable spread between deposit and lending rates - ranging between five and six percent on average against two percent worldwide.

While briefing the committee, State Bank Governor Shamshad Akhtar said that the compulsion of ensuring proper liquidity management and to control inflation had made the government increase the rate of interest. She claimed that the "real interest rate" was not higher than 1.5 percent. Chaired by Senator Ahmed Ali, the committee decided that matters pertaining to the State Bank would be discussed at another meeting to be held in Karachi during the first week of December.

Talking to the newsmen, after the meeting, some members expressed their surprise over the logic of the Governor State Bank that after deduction of the rate of inflation the "real interest rate" was not higher than 1.5 percent. Why she does not apply this criteria in the case of depositors, specially the small ones who were being paid a total of, on an average, three percent profit on their deposits. This is another side of story that one of the basic objectives of the central bank's decision (allowing gradual increase in the lending rate during the last about 14 months) to ensure enhanced and fair return to the depositors has not materialized. This policy has only soared the profits of the commercial banks. On the other hand the increasing rates are damaging the pace of country's exports. The Senate standing committee members said that they would discuss the issue in detail at the next meeting and if necessary raise this matter in the Senate.

Financial institutions of the country have never had it so good. Their profits are at record levels due to high banking spread while the depositors are getting a raw deal, exemplified by a very low rate of return on their deposits. According to the latest data released by the State Bank of Pakistan, the situation seems to have worsened further during the recent past ending August 2006, rising to 7.3 percent as compared to 5.8 percent during the corresponding period last year, showing an increase of 25 percent or 150 basis points. The weighted average lending rate for all banks in August 2006 was 10.64 percent while the deposit rate was only 3.4 percent, indicating a spread as high as 7.5 percent. The increasing spread is despite the fact that a lot of persuasion has been made by the State Bank and other sane elements advising or dealing with the financial sector to reverse the trend and try to narrow the spread to international levels of about 2-3 percent.

Many reasons are offered for the widening gap between lending and deposit rates. It is argued that the share of costlier credit is rising in the banking sector, which is pushing up the overall lending rates. Of late, banks have focused on consumer financing, with its share rising to 13.1 percent of the total lending. Yielding a rate of return of almost 18 percent, consumer financing is easier to manage and pays handsome dividends in a relatively short period of time. It also suits the government because it conveys an impression of prosperity. The SME sector, which now constitutes 17.3 percent of the total borrowing, also receives loans at a high rate ranging between 15 and 16 percent while the agriculture sector borrows at 13-14 percent. Low rate of return on deposits is attributed to the fact that ordinary depositors are not opting for fixed deposits paying higher interest rates and only fresh deposits are offered higher rate of returns. Whether the government decision to allow the institutions to invest in the National Saving Schemes (SS) with effect from 2nd October 2006 would put pressure on the banks to increase the deposit rates is also difficult to say. They could try to compensate the institutional investors and shrug off the signals as far as ordinary depositors are concerned, believing that they are captive customers.

In a report titled "Determinants of savings in Pakistan", the World Bank has argued forcefully that if the country wants to sustain its growth and increase investment without paying out an increasing share of its income in interest or dividends, it has to finance investment by raising its domestic savings rate. The bank has also questioned how, with low domestic savings rate, the economic growth can sustain itself.

There is absolutely no doubt about the validity or suitability of World Bank's findings in the current economic environment of Pakistan. The emphasis on domestic savings highlighting all the related issues is definitely right and to the point. It needs to be remembered, however, that the subject has also been previously studied in detail and the conclusions have been pointed out to the policy makers a number of times, but without much impact. In fact, the situation on the ground has been quite reverse in recent years and domestic savings as a percentage of GDP have declined from 18.1 in 2000-01 to 14.4 in 2005-06.

There are two factors contributing to this scenario: One is the sharp reduction in the rate of profit on the national saving scheme and the other is the flawed strategy of the government to promote consumerism. The key to sustaining or fostering development can of course be found in increasing domestic savings rate to approximately 20-25 percent of GDP. This is difficult but achievable. Most of the comparable economies in South East Asia are already generating this level of savings. The only condition is that we, as individuals and as a nation, have to change our attitudes and habits. Thrift has to be encouraged and consumerism discouraged at all levels and in every situation. The monetary and credit policy of the country is also not conducive for the promotion of financial savings at the moment. The will to save is hugely undermined by the low rate of returns on deposits, which are not even sufficient to cover the erosion of purchasing power of the rupee. In the last few years, our credit regime has also been geared to promote consumerism in society. It is the level of savings in the economy and not the flashy cars and energy-guzzling air-conditioners purchased through loans, which set the pace for future development.

It seems that the increasing interest rate are damaging the pace of high volumes of exports in the country. It is expected that the desired export target ($18 billion for the current year) would not be achieved through competition in the international market for textile products, high cost of business in the country, inflation and increasing interest rates in the wake of a tight monetary policy.

Exports of merchandise have declined by 3.24 percent during the first month (October 2006) of the second quarter of the fiscal year 2006-07, over the same month last year. The Federal Bureau of Statistics (FBS) indicated that exports had started declining from the first quarter (July-Oct 2006) of the current fiscal year. This means that exports dipped by 3.85 percent in July followed by 6.6 percent in August and 4.53 percent in September.

SBP measures have continued to remain ineffective and that too with multiplier effects. For one, it has badly damaged the volumes of exports.

The US Federal Reserve has raised its short-term lending rate to 5.25 percent. The Bank of England has recently increased the interest rate by 0.25 points. The Bank of Japan has ended its zero rate of interest and come up with a quarter percent interest. The European Union has reluctantly raised its rate to three percent lest it hurts its economic recovery. South Korea has an interest rate of 4.5 percent. India's short term lending rate is 6.34 percent, while Pakistan's lending rate is 10.1 percent. The Bank of China has increased its lending rate to 6.12 percent and raised its deposit rate to 2.52 percent. It has raised both the rates by a uniform 0.27 percent.

Economics is a complicated subject which requires diversified expertise and not just confined to mere banking and finance, commerce, industry, imports and exports, currency management and many more. Tightening of the monetary policy alone cannot check high levels of inflation and price hike. High interest rates constitute a bar on the high pace of exports, especially the export of textiles.

According to a highly placed source who wished anonymity, inflation in Pakistan cannot be controlled through tight monetary polices alone. This approach adopted by the State Bank - known in the financial world as Cheago School of thought (IMF approach) - is not effective in ease of developing countries like Pakistan where food inflation is higher than core inflation.

Elaborating, he said that inflation in a country is a sum total of three components i.e. food, fuel and non-food and non-fuel inflation, which is described as core inflation. Sources of inflation are increase in the prices of food items, increase in prices of fuel leading to increase of transport charges and the excessive demand. Inflation caused by excessive demand is a common phenomenon in developed countries where share of food and energy in a family budget is lesser than other expenses.

In such countries the tight monetary approach has and can prove effective but the situation in Pakistan is different. Here the inflation, as per Economic Survey 2005-06, constitutes 40.3 percent for food, energy and transport 15 percent and remaining 42.7 percent caused by other factors called as core inflation.

According to the source, the State Bank of Pakistan over-reacted and introduced tight monetary policy which only related to 42.7 percent and had no effect or hearing on the remaining 47.3 percent inflation from which the majority of the people are suffering in this country. In fact the tight monetary measures were mainly increasing the lending rates but failed to provide any relief to the general public. Instead it has multiplied the profits of the commercial banks. What is more annoying is the fact that we failed to ensure that small depositors also get some share from the soaring profits of the banks. According to a report commercial banks' profit has soured to Rs.93 billion in 2005 as against Rs.7 billion in 2001. The banks are obviously the biggest supporters of the policies of the State Bank.

The source, however, did not agree with the contention that increased lending rates by the banks had adversely affected our exports specially the textile sector. Bank charges and fuel and energy cost come to hardly three percent of the total cost of production and slight increase or decrease in that quantum would not make much difference. There are other reasons for the decline in our exports, he said, adding that two generations of our textile manufacturers have worked under protection of quota system and have become used to it. It is no more available and now they are faced with a highly competitive environment. Now they will have to learn to live and survive in a world of tough competition. They did not have the foresight and failed to prepare themselves in advance for the competition, which they are facing now. Now they have awoken to the new realities. They would take sometime to learn the art of surviving in the highly competitive business environment.

About the inflation of food items which has hit the double digit in Pakistan, the source said it was mainly caused by few food items like milk and milk products, onions, potatoes, tomatoes, chilies, farm eggs, chicken, mutton and some other items which fall in the purview of Ministry of Food, Agriculture and Livestock. Strange enough is the fact that the ministry never took any notice of these items to this effect - perhaps it did not have any data about the production or consumption of these items in the country. The ministry is merely concerned with the production of wheat, cotton and rice and it virtually seems oblivious of the two other components i.e. food and livestock. How you can increase the supply of these food items in order to bring down their prices to a reasonable and affordable level without the active participation of the ministry. For that you have to awaken the ministry from its deep slumber, the source maintained.