Monetary tightening measures taken by SBP have resulted in a visible decline in the private sector credit off-take

Dec 04 - Dec 10, 2006

Moody's Investors Service has announced Pakistan's revised rating, highlighting the country's ongoing economic growth coupled with a relative fiscal restraint over the past few years. Despite its optimism on the overall economy, the agency did not hesitate in expressing its reservation regarding persistent inflationary pressures, deteriorating current account balance and relaxation in the fiscal stance. Accumulating foreign debt for domestic currency supply should allow GoP to substitute its borrowing from State Bank of Pakistan (SBP), which creates syniorage (monetary inflation). Thus in affect a build up in foreign debt for currency stability would have to be sterilized by the central bank, which in turn will be counter inflationary and may offset some of the impact of fiscal financing.

The monetary tightening measures taken by SBP in the last few months have resulted in a visible decline in the growth in private sector credit off-take. This is pretty evident from the latest statistics released by the central bank for the period 1st July 2005 to 11th November 2006. Analyzing the potential implications of the decline in credit off-take on the future economic growth and interest rates in the country should be of some interest.

Total private sector credit off-take during this period dropped to Rs 87.5 billion (+4.4% YTD) as compared to Rs 144.3 billion (+8.5% YTD) during the same period last year. The slowdown in the credit off-take indicates a slowdown in the credit led investment growth in the economy. In addition, some of the blue chip companies in the telecom and FMCGs sector namely Warid, Mobilink and Nestle have obtained huge loans from the international capital markets, which also kept the growth in local credit off-take subdued.

The slowdown in credit off-take is particularly severe in the textile sector, which has come under tremendous pressure during last 6 to 8 months. Since textile sector forms over 25% (as per Pakistan's Economic Survey 2005-06) of the total credit off-take in the country, the decline seems to be more pronounced. Both the capital investment and working capital loans in the sector have come down drastically this time, as most of the mills are operating at low capacity utilization levels. This has been caused by intense competition in the international market, which has significantly hampered the export growth. In addition, the cement sector, which had invested heavily in capacity enhancement last year, is also taking a breather. Consumer and SMEs, fertilizer and power sectors on the other hand are showing strengths, thus compensating, to an extent, of the decline in the textile sector.

Looking at the current scenario, it seems highly unlikely that the government is going to meet its target of Rs 390 billion in private sector loans. The forecast off-take could range from Rs 275-300 billion during the current financial year. The sharp decline in private sector credit off-take (especially in the textile sector) and the resultant slowdown in the credit led investment in the economy imply that the industrial sector growth in the country could also start to come down starting from next year. This could affect the overall economic growth.

Many analysts are of the view that the interest rates could come down due to decline in core inflation. Now having seen the private sector credit off-take come down drastically the view of an interest rate decline in the next six months is further reinforced. In order to balance the dual role of ensuring economic growth and controlling inflation, one can expect a change of stance of SBP in the monetary policy statement to be released this month.

During the last nine T-Bills auctions the central bank has kept the cut-off yield almost flat. It has been raising maximum amounts through three and twelve months bills. This clearly shows its policy stance towards short and medium term interest rates. Mobilizing money through three months bills exhibits its intention of avoiding liquidity crunch as well as curbing hoarding of essential food items. As regards mobilizing resources through 12-month bills, it shows that both the central bank as well as primary dealers believe that further hike in interest rates may not be possible and keeping short-term interest rates stable.

Analysts are all of the view that hike in interest rates has not helped contain inflation rate but certainly contributed to declining private sector borrowing. Most of the analysts are of the view that inflation rate in Pakistan is not interest rate driven. It is an outcome of cost pushed inflation, the most contributing factor being oil prices in the recent past. It still remains a serious issue because the government has been resisting reduction in POL prices, saying that it wished to recover the losses incurred when crude oil was touching US$ 78 per barrel. Therefore, the consensus is that government should float bonds of longer tenure and let the cut-off yield on up to 12-month T-Bills crawl down.

It is believed that the government plans to issue 30-year bond. Considering the tenor of the bond, it seems that it will be difficult for people in Pakistan to invest in such a longer-term instrument. The reasons for this reluctance include liquidity risk, interest rate outlook and uncertainty in political situation. The 30-year bond would help the government form a proper yield curve, which assists in analyzing the costs and returns of long-term projects and instruments.

Various analyses show that the impact of change on interest rates for 30-year bond is not significantly higher than that for 15 and 20 years. The reason for lesser difference in durations of 15, 20 and 30 years is that for longer tenor bonds, principal payment isn't very critical as compared to coupon payments. Besides, the government has already issued 30-year Eurobond in the international market, which received a very good response. Therefore, it would be a good investment opportunity for the local institutions to place their funds for longer term. Although the duration for Eurobonds is higher (due to lower yield offered by the government), a lot of investment has been made in those bonds and its current secondary market yield is lower than the cutoff yield.

Although the 30-year bond gives a good avenue for investment, it should be kept in mind that the response in 15 and 20-year bonds was too low as compared to 10 year bond. The reason for lower participation is that the duration for 15-year bond is much more than that of 10 years. Longer tenor bonds have usually not been preferred by commercial banks as a result of very low liquidity. Insurance sector is the biggest investor in these instruments, as the nature of their business requires long-term safe investments. Retail investors have remained shy of investment in government bonds as they have a much attractive alternate for risk-free investment i.e. National Saving Scheme. Similarly, the institutions would also prefer investing in NSS as compared to taking position in bonds.

Globally, retailers - including professionals and businessmen - are a big source of investment in the government instruments, as they get good returns on a safe investment. In Pakistan, this trend is not visible due to lack of depth in the market, which increases the transaction cost for the investor. In the US, the re-issuance of 30-year bond was well responded by the market. In fact, the government has been suggested to issue 50-year bond to tap the investor demand. Despite the issuance of longer tenor bonds in past few years, the Pakistani market still remains far behind in terms of investor interest and activity in the bond market.

Any hike in inflation leads to reduction in GDP growth. Rise in inflation creates uncertainty in investment, results in increasing cost of doing business, erodes purchasing power and reduces consumption and leads to political turmoil by widening income disparities. If inflation remains unchecked, the steam in the economic momentum would fizzle out. To solve this problem a prudent central bank raises the interest rates to reduce the money supply and control inflation. This is indeed what the SBP has been doing in the recent past.

If the rise in interest rates is successful in curbing inflation, its impact on economic growth can be termed positive. However, there is a time lag between rise in interest rates and reduction in inflation. During this time lag, a rise in interest rates often has negative impact on consumption and industrial investment. However, in Pakistan the industrial sector has already invested heavily in BMR. The production from this capacity expansion has started pouring and would be propelling growth in industrial production and exports.

Equities prices and fixed bond yields generally move in opposite direction. Historically, any reduction in money supply has dampening effect on the index. However, the direction of the equity prices and indeed the long run growth is dependant on a number of factors that include economic growth, political outlook and corporate earnings potential. Lately, corporate sector has also started mobilizing funds from the international market.

MCB Bank has successfully mobilized US$ 150 million through GDR issue. Mobilink has entered global market by making offer for raising US$ 250 million. The latest endeavor is by OGDC for mobilizing more than US$ 800 million. Other entities in the process of issuing GDRs are National Bank, United Bank, Habib Bank and KAPCO. This shows that there would be less pressure in the domestic market, which should ideally lead to lower private sector credit off-take and declining trend in interest rates.

The inflow of FDI and portfolio investment should also help in raising foreign exchange reserves and in turn easing pressure on exchange rate. It is ironic that some leaders of Pakistan's business community are suggesting devaluation of Pak rupee. Perhaps they do not realize the severe and grave impact of this move. Devaluation has neither helped in the past nor could it help in future in boosting exports and curtailing imports.