RISING INTEREST RATES

Impact on various sectors of the economy

By SHABBIR H. KAZMI
July 25 - 31, 2005

The State Bank of Pakistan (SBP) has released its Monetary Policy Statement for July-December period of 2005. It is an extension of the policy the central bank has been following since January this year. There is nothing to surprise in the policy as the key objectives remain intact i.e. 1) containing inflation and 2) facilitation of investment. One may say that the policy is neutral but the central bank has clearly indicated that if inflation remains high, it would take the necessary measures.

Without taking the absolute numbers into account and the potential impact of the possible measures the SBP may be taking, it appears that the rise in interest rates will not be as sharp as was witnessed over the last 12 to 18 months. Most of the analysts believe that interest rates have already started flattening. Some of them even say that the rates may experience declining trend in the longer run. To support their point of view they refer to two factors 1) SBP maintaining average yield on 6-month Treasury Bills around the same level in the last two auctions and 2) the central bank showing no inclination towards undertaking fresh auction of Pakistan Investment Bonds (PIBs).

It is evident that the Government of Pakistan (GoP) is keen in accelerating the GDP growth rate. The GoP has fixed a growth target of 7 percent for the current financial year and wishes to facilitate private sector borrowing, both in the manufacturing and agriculture sectors. The strategy is aimed at creating new employment opportunities, improving quality of locally manufactured goods, achieving higher exportable surpluses and above all enhancing purchasing power of people. To achieve these objectives it is necessary that interest rates remain attractive for borrowing. The government does not wish to see slow down of the ongoing creation of new productive facilities and upgrading of the existing facilities.

However, in an attempt to contain the inflation the SBP has been following crawling increase in the interest rate. Many of the economists are of the view that inflation cannot be contained simply by increasing interest rates. Therefore, it is necessary to understand the reasons for the rising inflation rate in the country. It was said that inflation rate was going up due to rising demand of the domestically produced goods. The most referred products were POL, consumer goods, cement and sugar. Economists say that the hike in POL prices is an aftermath of the rising international prices of crude oil. When the prices were touching the peak government did try to contain the prices. As the prices started easing government decided to pass the impact on to the consumers. It is believed that crude prices will come down rather than going up in the near future. Saying this, it is also important to keep in mind that prices would never plunge to the past levels. Price per barrel of crude will hover around 55 dollars in short to medium term. Prices of sugar and cement had gone up due to growing gap between demand and supply. The decision of government to allow import of both the commodities is expected to bring down their prices. Therefore, it may be said that the important contributors to the inflation are largely outside government's ability to control through monetary policy.

According to Elixir Securities Pakistan, the CPI inflation is expected to remain around 8.5 percent. One may not witness further tightening of the monetary policy. The average yield on benchmark 6-month T-Bills may also hover around 8 percent and yield on longer term bonds would also remain under 10 percent per annum. However, tightening of the policy will be necessary if inflation rate exceeds 9 percent. It may not be wrong to say that even if the government continues to follow crawling increase in interest rates, it will have only a marginal affect. The SBP has been saying repeatedly that it does not wish to interrupt the ongoing process of economic growth. Along with this, efforts to improve supply are expected to have a snowball effect on the economy. Improving purchasing power facilitates demand growth and creation of new productive facilities adds new job opportunities in the country.

Having said this it is important to explore the impact of interest rate movement on various sectors of the economy. Banking is a sector on which the impact of interest rates movement is most prominent. Interest rates movement and resulting spread impact the earnings of banks. Over the years there has been growth in deposits but returns on deposits have remained negative, keeping in view the rate of inflation. While the banks have been prompt in increasing the lending rates, they did not improve the return on deposits accordingly. This policy has been helping them improve the spread.

According to some analysts five factors are contributing to enhanced earnings of the banks significantly. These are 1) yield on government securities, 2) private sector credit off take, 3) disbursement to farmers, 4) international trade business and 5) volume of consumer finance. At the same time expenses are also rising. A significant part of these expenses pertain to expansion and development. While some analysts call it expenses others call it investment in future, but these do affect the cash flow and bottom line. A concern is will the banks be able to maintain the spread at current levels? In a highly competitive environment a lot depends on the strategy being followed. There should be efforts to increase volume of business without compromising the quality or the level of prudence.

Agriculture is the most important sector of Pakistan's economy. However, income of farmers is directly linked with the prices of various produce. In order to enhance production of food and cash crops the government has been raising support prices of these commodities. This automatically takes care of the rising input cost. However, the improvement in yields due to adequate availability of water and use of appropriate dosage of nutrient contents is having positive impact on the earnings of the farmers. The improved earnings allow the farmers to spend more, which in turn has a positive impact on the manufacturing sector. The impact of improved earnings of rural population is visible on the manufacturers of consumer goods, agricultural inputs and implements, automobiles (both two wheelers and four wheelers).

Lending for implements may be a little safe because of collateral. However, lending based on the crops could prove disastrous in case of any natural calamity. This point must be kept in mind by the lenders because crop insurance is not in practice in Pakistan. It is time that banks, in collaboration with insurance companies, pave way for crop insurance. It is not too difficult because now sponsors of commercial banks also enjoy stake in insurance companies.

It is necessary to point out that experts have been saying that with the rise in interest, consumer finance business would get a setback. However, the rising quantum of auto finance has proved these apprehensions baseless. During the month of June auto financing was provided for 1,400 cars against a monthly average of 700 cars. In the absence of detailed data about financing of other consumer durables it is not possible to quantify the real impact. However, the overwhelming perception is that sales of consumer durables are showing no signs of deceleration.

In the latest Monetary Policy Statement the target of private sector borrowing has been fixed at Rs 330 billion, higher than last year's target. One may ask, is this an ambitious target or a realistic and achievable benchmark? Most of the economists are of the view that the target is realistic and achievable. To substantiate their belief they say, "In the late nineties the country was suffering from poor capacity utilization in the industrial sector. As against this most of the sectors after having achieved optimum capacity utilization are going through massive capacity expansion at present. The sectors witnessing colossal capacity expansion are: banking, oil and gas, telecommunication and information technology, transport and infrastructure, cement, automobiles and fast moving consumer goods.

Liberalization, deregulation and privatization policy being followed by the GoP is not only gradually bringing various sectors under private sector management but also witnessing major investment by the new strategic buyers. It is on record that with the transfer of ownership and management control of state-owned cement manufacturing plants to the private sector billions of dollars have been invested to expand capacity. Telecommunication sector has not only attracted a record investment but privatization of Pakistan Telecommunication Company (PTCL) will provide the new impetus.

Yet another sector to experience major investment is oil refining. Reportedly Attock Group, the buyer of National Refinery, will be undertaking a major expansion plan shortly. The buyer and the newly acquired entity are not only cash rich but have very low debt. It is said that the rise in crude prices is not because of supply concerns but limited refining capacity around the globe. Pakistan suffers from two problems 1) the existing refineries are based on very old technology and 2) capacity expansion over the years has been limited. Both the refineries (NRL as well as PRL) enjoy the location advantage.

According to some analysts the three sectors expected to attract substantial investment in the near future are 1) construction, 2) power generation and 3) public transport. The boom in construction is already evident, though there has been some interruption due to hike in cement prices. A vibrant construction sector serves as growth engine for more than 40 industries. The biggest contribution of this sector, being labour intensive, is creation of enormous employment opportunities.

The accelerated economic growth has already started widening the gap between demand and supply of electricity. Though, the GoP has been repeatedly expressing its resolve to construct dams (also capable of producing hydro electricity) work on any mega project has not started as yet. Even if the work starts immediately, it will take another five to ten years to bring these projects on line. Therefore, a few independent power projects have to be constructed immediately to avoid the situation Pakistan had faced in the nineties.

Though, the overall public transport quality is pathetically poor throughout the county, it is the worst in Karachi. The government is bent upon reviving the Karachi Circular Railway to overcome the chaotic situation. However, many transporter sector analysts consider it a very bad proposal. Some of them want the government to ensure financing of buses, not the mini-buses, to overcome the crisis. The last major induction in the public transport system was in nineties. The recent initiative by SMEDA did see induction of some buses but the number is highly inadequate.