By raising the yields by around 100bps in the last
3-month and 12-month T-Bill auction the SBP has removed all doubts
that interest rates are going to stick around the corner for long. The
upward direction has been set with great pace and visible very
clearly. With SBP raising interest rates by huge quantum to fight
inflation, several sectors of the economy will face increased
financial charges. While some may not face the impact, some are
actually benefit from the hike in interest rates.
According to a report by Alfalah Securities,
short-run economic growth tends to follow cycles. The objective of any
central bank is to ensure that the cycles are minimized and the
economy remains on a long-run growth path. Interest rates are one of
the monetary policy tools available with the central bank to meet this
objective. When the economy is in a recession, the central bank
reduces the interest rates to spur growth in money supply. This
reduction in interest rates gives incentive to increase domestic
spending. Indeed, the reduction in interest rates in Pakistan led to a
boom in domestic demand (currently at 56% of GDP). The boom in
consumption pulled up demand for industrial products like automobiles,
consumer durables, housing, cement, steel and services etc.
The growth in industrial sector improves urban
household income, which leads to growth in the services sector. The
growth in GDP improves government's tax revenues and allows it to
provide more subsidies and incentives to the agriculture sector. The
growth in consumption demand leads to increase in capacity utilization
in the industrial sectors. However, the growth in money supply (due to
higher demand) leads to inflation as there is more money chasing fewer
goods. At this time, the central bank has to ensure that inflation is
curbed (by raising interest rates) and at the same time the growth
momentum is not damaged.
According to a World Bank study a rise in inflation
to 10% leads to a reduction in GDP growth by 0.4%. How does this come
about? Rise in inflation 1) creates uncertainty in investment, 2)
leads to an increase in the cost of doing business, 3) erodes
purchasing power and hence reduces consumption demand and 4) 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.
If the rise in interest rates is successful in
curbing inflation, its impact on economic growth should be 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
would play negatively on consumption demand and industrial investment.
However, in Pakistan the industrial sector has already invested
heavily for BMR. The production from this capacity expansion would
come about by the next year and would be propellant for the growth in
Equities prices and fixed bond yields generally
tend to move opposite to each other. Empirically for KSE, a reduction
in money supply leads to a dampening of growth of the index. So rising
interest rates should theoretically, dampen the market. However, the
direction of the equity prices and indeed the long run growth is
dependant on factors like economic growth, political outlook and
corporate earnings. All these three factors are positive for Pakistan.
Hence, the doomsayers have less ground to support their view.
InvestCap has analyzed the impact of rising
interest on listed companies. According to their report, companies
with huge debts on their books will suffer the most from the
increasing interest rates. Usually, companies have debt with floating
rates linked to KIBOR or T-Bill. Of late, most of these debts come
without a cap or a floor, which further exposes these companies to the
interest rate risk. Of course then, as rates rise, so do their
Cement sector companies will have to suffer quite a
burn as many cement companies have borrowed huge amounts of money to
materialize the expansions.
Gas distribution companies will also face increased
cost because of their ambitious capex program. As of March 2005, the
combined debt to equity ratio of the two Sui companies stood at a high
Fertilizer companies, Textile, PSF and Airlines
will also experience a hit due to the increasing interest rates, as
they too carry big loans on their books.
In the telecom sector, the giant is almost debt
free. However, the smaller new start-ups are literally leveraged to
the hilt. These small companies will consequently have to bear the
price of being leveraged.
Banks will gain from rising yields on investments
and advances. Although deposit rates have also started to rise on
fixed term deposits, most of the local deposits still lie in the
current and saving accounts, where returns are pretty low. The
greatest benefit will go to the banks that have more space left to
indulge in higher yielding securities now.