FINANCE

 

INFLATION AND INTEREST RATE GO TOGETHER

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Interest rates to increase further: Governor SBP

 

By AMANULLAH BASHAR
June 20 - 26, 2005
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Interest rates in Pakistan have a direct link with inflation, if inflation goes on the increase, the interest rates would go up automatically. To judge the movement of interest rates one must keep in mind that as and when inflation increases or decreases interest rates would automatically go up or down accordingly.

These outlines on movement of inflation and the interest rates were given by the Governor State Bank of Pakistan (SBP), Dr. Ishrat Hussain, last week at a meeting held at the SITE Association of Industry where he predicted that banking interest rates will go up further in near future. In conformity to this guideline it seems that the inflationary pressure should also be mounting in the days to come.

It is, however, amazing to note that some leading analysts feel that with the Consumer Price Index which according to them was showing sign of tapering off, coming down to 9.84%YoY in May-05 as compared to 11.1%YoY in April-05, the interest rates should also respond to the declining inflation.

Increase in food prices, which had been the major driver behind the growth in CPI increased by 12.5%YoY as compared to 15.7%YoY in May 2005. Growth in house rent remained stubborn at 12%YoY.

The major reason for the decline in the growth rate of CPI is not a fall in the price level but rather it is due to a high base effect, Alfallah Securities observes in its analytical comments on inflationary pressures.

The relief measures taken by the government to control food inflation, like import of food from India would still take a few months to impact the price index.

Inflation has a strong inertia and hence any policy measure usually takes a long lag before making a visible impact. The positive indicator, however, is the decline in the growth in core inflation, which came down to 7.9%YoY from 8.4%YoY last month.

Although inflation would come down from its current levels, yet it would remain on the higher side, due to the expansionary budget planned for FY06. It is, however, estimated that inflation would remain in the range of 8.5%-9.5% in FY06.

The government has scrapped the last PIB auction, keeping the coupon rates on PIB tied down. However, higher government borrowing planned for FY06, would prevent the interest rates from coming down massively from the current levels before second half of the new fiscal year.

Dr. Ishrat Hussain, however, paid glowing tributes to reform process, adopted in National Saving Centers, due to which the banks were saved from becoming penniless.

Interest rates in Pakistan, Governor SBP feels, are still on the lower side and depositors, who are the backbone of the banking sector, are getting a meager rate of return on their savings. For example, if inflation is 10 percent then interest rate must be 11 percent, the governor pointed out. Frequent changes in interest rates put into jeopardy feasibility reports of projects and pricing of industrial products meant for exports. He advised the business community and industrialists to employ professionals in management and give up old practice of employing family members.

Banking methods have changed and now business practices must also be changed to cope with the changing business scenario in the world. If the existing interest rate is only 3 percent then the professionals would not base and prepare feasibility report on this interest rate. A professional would prepare the feasibility keeping in mind future conditions, he sounded an advisory note.

Increase in interest rates with a view to protect the interest of the banks and the depositors seems valid to a great extent, yet the increase in interest rates may adversely fall out on the booming consumer finance business which set a record growth of over Rs400 billion during 2004-05. It was because of low interest rate which contributed unprecedented growth in car financing and house financing sectors. If the interest rates continued to move on the higher side, the new financing year may not be able to keep up bustling consumer market in Pakistan.

Owais Kalia, Vice Chairman, Kalia Group, who is a leading financial analyst, however, feels the pinch of the growing inflationary pressures especially on the low income group. He was of the view that the steps taken by the central bank to increase the discount rates of the banks was in right direction because economic activity in a certain area at the cost of the interest of the masses cannot be advisable in any sense. Actually, the mounting inflationary pressures may prove counter productive to the government efforts for poverty alleviation, hence the situation calls for effective check before the inflation goes wild any more, Owais Kalia observed.

Earlier, the banks were in the public sector, therefore banking officers had no interest in banking profession. They only cared for salary and increments and paid no heed to bank's clients. Consequently, non-performing loans were accumulated and reached unbelievable heights. Except one, no bank used to provide agricultural loans. Resultantly, interest rates were very high. There were times when Pakistan had no finances to pay for the oil bill and the country was going to be declared bankrupt. In those conditions the present government took over the command of the country and initiated reform program, including reform in banking sector.

At present, professional managements are running the banks. Except one bank, all banks have been privatized. The banking practices have changed drastically and the banks are providing housing finances, consumer loans, agriculture loans, SME loans, project finances, etc.

There was yet another concept that cash flow in the form of home remittances was creating inflation in the country. The Governor SBP has, however, dispelled the concept with the remarks that Pakistani laborers and skilled workers are sending remittances home for families' support. Banks convert these remittances into Pak rupees and then give it to them. Out of the total remittances of $4 billion received annually, $3 billion are spent on families' support including children's school fees, food, maintenance and other expenses of the families. While the remaining one billion dollars are invested in purchase of land and houses in urban or rural areas to have a house or future plans to get in cultivation on their return to Pakistan. Unfortunately, educated people do not send remittances, as majority of them generally desire to stay back and settle abroad.

 

 

Commenting on inflationary numbers, Analysts from Live Securities feel that inflationary trend signaled a slowdown in May 2005 on the back of improving domestic food supplies, especially that of wheat which is the basic food item in our society. A bumper wheat crop of 21.4 million tons has helped bring down the domestic price of flour. Further, the monetary policy tightened by the central bank was also playing its part.

Food and beverages component of the CPI, which has an over 40% weightage in the index, rose 12.55% in May. This portrays an approx. 3.15pps slowdown as against 15.7% increase during the previous month. Fuel and lighting rose 4.59% during May 2005, marginally lower compared to 4.96% previously. The house rent component of CPI surged 12.05%, almost identical compared to 12.07% during April 2005.

CPI has been significantly fuelled by the rise in oil prices. Since mid-December 2004, the government has raised domestic petroleum prices several times by a cumulative approx. 22-24%. Oil inflation has a chain effect on most economic sub-sectors as it effectively raises the aggregate cost of industrial production. Lower inflation during May 2005 also emanates from the fact that no increase was made in domestic oil prices during the earlier couple of weeks.

Oil Companies Advisory Committee (OCAC) has maintained petroleum prices despite the significant firming up on the international front. This indicates that the government continues to absorb bulk of the oil price increase. If the firm global crude oil price trend persists, an increase in the domestic front may be inevitable. An argument that supports this is the fact that for FY2005-06, the government has budgeted Rs15.9bn Petroleum Development Levy (PDL). This portrays a 47% increase compared to the Rs10.8bn revised estimate for FY05.

On the back of the tightening monetary policy stance adopted by the SBP, secondary market yields have firmed up considerably in recent months. Earlier, the discount rate was also raised by 150bps to 9%. Given the current inflationary numbers, it seems that interest rates have reached their short-term peak. Consequently, in the Treasury Bill auction next week, cut-off rates are likely to be unchanged or may even portray a minor reduction.

BIGGEST CONCERN

In view of Dr. Ikhtiar Baig, the biggest concern of the industries is the rising inflation to double digit from July 2004 to April 2005. The Consumer Price Index (CPI) average was 9.3 percent as against 3.9 percent of last year. Similarly, (Sensitive Price Index) SPI was 11.5 percent, giving very adverse effect on the poor and vulnerable society of low-income group.

On the question of rising markup rates the SITE Chairman remarked: "We understand that the SBP is doing their best to have a tight monitoring policy to control the increasing private sector credit with a view to contain inflation. However, after the post quota regime, the local industry cannot afford substantial increase in the financial cost.

On an average, the financial cost of the companies increased more than double in some cases three times in the previous year. Particularly, the manifold increase in export refinance rates has made exports incompetitive in the world market. Export refinance rate should be de-linked on the basis of weighted average six months Treasury Bill Rate as it was the condition of IMF, which is not applicable any more from Jan 2005.

The system of lending on KIBOR has been failed and taken interest rates to double digit, the same to be reviewed to boost the new investment in the industry.

Rising inflation to double digit from July 2004 to April 2005 was yet another serious concern of the trade and industry. CPI average at 9.3% as against 3.9% last year speaks itself formidably. Similarly, SPI were 11.5% giving very adverse effect on the poor and venerable society of low-income group.

The industrialists, however, appreciated the efforts of the central bank to control inflation through tight monitory policy but strongly felt that other measures should also be taken to control the inflation.

Increase in the oil price in the international market was one of the causes for high rate of inflation in Pakistan. The trade and industry representative appreciated the Governor's recommendations to withdraw fuel surcharge from the utility bills to bring their prices down.

The government was urged to ensure smooth supply of essential food items on the principles of economics i.e. demand and supply.

The government has allowed duty free import of essential food items but it is too late. Concessional financing allowed on wheat/grain also encouraged holding of wheat stocks/inventory by the hoarders causing artificial shortage in the domestic market leading to increase in flour prices in the market. Concessionary financing should not be allowed on grains with a view to discourage hoarding.

INTEREST RATE SPREAD (PERCENT)

 

YIELD ON EARNING ASSETS (A)

COST OF INTEREST LIABILITIES (B)

SPREAD (A-B)

CY91

10.1

5.8

4.4

CY92

9.8

5.3

4.4

CY93

11.0

6.2

4.8

CY94

10.9

6.3

4.6

CY95

11.8

6.9

4.9

CY96

11.2

7.4

3.8

CY97

13.5

8.3

5.2

CY98

13.8

8.5

5.3

CY99

13.0

7.4

5.6

CY00

11.2

6.6

4.6

CY01

11.2

6.0

5.2

CY02

9.0

4.3

4.7

CY03

6.1

2.0

4.1

Note: where (a) is computed by dividing interest income with earning assets (Advances + Investment + Money at call). While (b) is the ratio of interest expense to sum of deposit and borrowings.

 


 

 

WA Lending rates*

WA Deposit rates

Jun-99

14.60

8.39

Jun-00

12.94

5.89

Jun-01

13.97

5.00

Jun-02

12.12

4.17

Jun-03

7.58

1.90

Jul-03**

5.12

1.00

Aug-03

5.09

0.77

Sep-03

5.20

0.85

Oct-03

5.32

0.80

Nov-03

5.29

0.81

Dec-03

5.68

1.22

Jan-04

5.04

1.12

Feb-04

5.30

1.30

Mar-04

4.69

1.33

Apr-04

5.07

1.36

May-04

5.42

1.35

Jun-04

5.05

1.19

Jul-04

4.63

1.20

Aug-04

5.08

1.51

Sep-04

5.84

1.69

Oct-04

6.01

1.53

Nov-04

5.94

1.61

Dec-04

5.92

1.78

Jan-05

6.68

1.75

Feb-05

6.17

1.74

Mar-05

6.57

2.22