INTEREST RATES AND THE ECONOMY

AROOJ ASGHAR (arooj.asghar@crosby.com)
Feb 25 - Mar 02, 2008

State Bank of Pakistan (SBP) is in a monetary tightening phase raising discount rates continuously for the last few years. Initially, SBP raised policy discount rate by 150 basis points in April 2005 but persistent demand pressures in the economy forced it to add further 50 basis points each in first and second half of current fiscal year. Central bank is taking certain corrective measures to prevent the economy from intemperate inflation, growing circulation of money and probable decline in the growth rate in fiscal year 2007-08. Monetary Policy Statement covering period July December 2007 recognized that it has missed the current fiscal year's target of money supply growth due to heavy foreign exchange inflows. In addition to that, as per the Monetary Policy Statement of SBP covering period January June 2008, quote, "The tight monetary policy stance, especially since the previous policy rate increase, has begun to lose some of its steam. A moderate increase in KIBOR and banks' lending rates, almost flat Monetary Conditions Index (MCI), a fall in the effective CRR, and persistently high annualized M2 growth rate are all manifestations of these developments" unquote. After this clear message of monetary tightening phase to the financial market in the coming months, it was inevitable for the SBP to push up the treasury bills' rates. In the auction conducted in January, 2008, the cut-off yield on the 12-month T-bills reached 9.97% as against the earlier rate of 9.495% while the cut-off yield on the 3-month bills touched 9.45%, up from 9.09%. The cut-off yield on six-month paper also rose to 9.73% from 9.29%. T-bills were 9.38%, 9.61% and 9.87% per annum respectively for 3, 6 and 12-month.

Pakistan's interbank money market faced latest liquidity crunch in mid February 2008 when banks were again forced to go to the central bank's window amid a lack of cash inflows. Overnight call rates ended at 10.5% and just above the 10.0% discount rate at which banks borrowed 43.05 billion rupees from the State Bank of Pakistan in the second week of February 2008 repo facility. Banks have borrowed 89.75 billion rupees in the week started February 11th. As said above, banks are facing liquidity crunch these days because of the outcome of the central bank's policy to keep the market dry in fear of inflationary pressure coming out from the inflows of dollars and building up of reserve money. Most of the loans and advances of scheduled banks are in three sectors i.e. agricultural, industrial and export which showed a mixed trend after the hike of interest rates. Whereas most of the sectors are reluctant in getting fresh credit lines due to increase in the financing cost. Various economists have consensus about the conduct of monetary policy which addresses specific policies called for in particular situations in Pakistan. The basic element of this consensus is that the instrument of monetary policy ought to be the interest rate. According to them, the policy should focus on the control of inflation where inflation can be reduced by increasing interest rates.

The central bank remained far behind the target it had set recently for the T-bills auction. It raised only Rs 45.58 billion through the auction as against the target of Rs 75 billion. In order to partly compensate for this shortfall, the SBP mopped up Rs 15.5 billion under its open market operations in treasury bills at a rate of 9.45%. The amount offered was only slightly higher at Rs 16 billion this time. Economist believe that current monetary policy stance of the SBP, has a sound rationale. In order to restrict the supply of credit and contain the growth of liquidity and control the mounting inflationary pressures in the economy, SBP is moving interest rate upwards. Needless to say, if the lending rates are raised, businessmen and the investors will be less tempted to borrow from the banking system and marginalize the use of credit. At the same time, depositors will be more inclined to save and postpone consumption. By taking these steps, SBP is trying to meet its objective of price stability. Few claim that the rate of inflation would have been much higher if the central bank had not been vigilant and wouldn't have taken restrictive measures in the past. On one hand it is trying to squeeze the liquidity of commercial banks by unloading the treasury bills in the market and on other it is increasing the cash margins which are the biggest source of credit creation. However, SBP can't take entire burden on it; other stakeholders are also required to come forward in achieving the monetary stability.

AVAILABLE OPTIONS

State Bank is attempting to achieve economic stability by varying the quantity of money in circulation, the cost and availability of credit, and the composition of a country's national debt. As known to most, SBP has three instruments to implement monetary policy: i) Open market operations ii) Reserve requirements iii) The 'Discount Window.

Open market operations - In recent months, SBP has taken certain steps in open market operations where it buys or sells T-bills in open market. Few years back SBP's intention was to expand the money supply where it bought from the open market and lowered the discount rates and KIBOR. With the robust growth in the economy and rise in the money circulation, SBP now intends to block the supply of money, for this it is selling T-bills in the open market and increasing discount rates gradually. This is most widely used instrument by SBP in day to day control of the money supply because of its ease of use and relatively smooth interaction it has with the economy as a whole.

Reserve requirements - Reserve requirements are a percentage of commercial banks' and other depository institutions' demand deposit liabilities that must be kept on deposit at the SBP as a requirement of banking regulations. In most of the cases, this percentage seldom changes but in recent months, SBP has changed this number of times, thereby affecting the money supply and credit conditions. SBP has also increased the Cash Reserve Requirement (CRR) from 5% to 7% on demand liabilities and the Statutory Liquidity Requirement (SLR) from 15% to 18% for the scheduled banks. At the same time, in order to incentivize banks to mobilize long-term deposits, SBP reduced the CRR on their time liabilities from 5% to 3%. SBP is trying to control the continuous rise in inflation and for that it intends to block the circulation of money which they believe can solely be done through increasing the interest rates. SBP has increased the reserve requirement percentage with the purpose of reducing the money supply by requiring a larger percentage of the banks, and depository institutions, thus taking them out of supply. Due to this increase, banks have lesser money to offer to their clients hence typical demand-supply theory applies here. With the lesser money to offer, banks will have to increase lending rates to discourage the borrowers to borrow money from them. Many experts believe that this type of action should only be performed occasionally as it affects money supply in a major way. As altering reserve requirements is not merely a short-term corrective measure, but a long-term shift in the money supply.

Discount Window - Another option which SBP has and exercises quite often is Discount Window. SBP offers funds to commercial banks, and other depository institutions at a discount rate. This rate is usually set below KIBOR. Therefore, by affecting the money supply, monetary policy establishes the ranges for inflation, unemployment, interest rates, and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

INFLATION

As the inflationary pressure is constantly building, the State Bank is raising interest rates regularly in an effort to keep the pace of economic growth consistent. Typically, higher borrowing costs slow the economy by forcing consumers and businesses to cut back on spending and investment. But the impacts of rising interest rates affect different groups in different ways. The SBP changes the economy by buying and selling T-bills to manipulate the discount rates the interest rate banks charge each other for overnight loans. When the discount rate rises, other interest rates tend to follow as lenders seek out the highest returns. For example, when the SBP raised its benchmark rate by a fifty basis point to 10.5% in January 2008, banks increased the KIBOR the price of borrowing for their customers by an identical amount, pushing the KIBOR to its highest level in last five years. Like KIBOR, other interest rates are also linked to the SBP discount rate but not always as tightly. Factors like the level of government borrowing and future inflation expectations effect the direction of interest rates. Certain economist believes that it can take as long as a year for higher rates to work their way through the economy and affect decisions by businesses and consumers. In fact, the economy actually sped up and grew at an annual rate of over 7% since the SBP started raising interest rates in 2005.

KIBOR MOVEMENT IN PAKISTAN

Table A presents the KIBOR from September 2001 till February 2008. A quick insight into the graph reflects the fluctuations in interest rate i.e. KIBOR and abrupt changes in the scenario leading to the requirements of "Swaps" and "Hedging" of interest rates in Pakistan. The trend line shows that KIBOR underwent sudden sharp decline from September 2001 to March 2002 from 10.4% to 2%, whereas it tended to keep hovering around at constant level till December 2002 and then nosedived by the end of March 2003. At this point, the KIBOR was as low as 2.5% or so. It remained at this low level for almost one year when in March 2004, it again geared up and started climbing. In September 2005 continuous hike led it to around 9% and this level maintained itself till June 2006, where again there was an upsurge of above 10% p.a. The doted parenthesis on the graph covers the period where KIBOR started increasing massively.

CONCERNS

It is also important to recognize the side effects of monetary policy tightening. Various circles have raised concerns on the increase in discount rates in July 2007 and January 2008. Apparently SBP intends to slow economic activity to stop inflationary pressures from building. It is evident that inflationary pressures have been building since last few years but particularly since second half of last fiscal year. Despite all measures, it appears that level of satisfaction is far away. It was expected that the rate increase which have already occurred is likely to have a large impact on the level of business activity. The most important source in which such pressures have occurred is in the form of higher price of imported crude oil. Federal government has not increased the oil prices for the last many months ignoring the fact that international oil prices have touched 100 dollar a barrel whereas oil prices in Pakistan are still fixed at around 60 dollar a barrel. Both food and non-food inflation are increasing despite the fact that government is heavily subsidizing the petrol prices. It is vital to note that prices of almost all the consumer products have increased recently which in coming days will again get additional rise when new elected government actually adjusts the local oil prices with the international price. Due to heavily subsidizing the oil prices, government is relying on the borrowing which is another source of higher interest rates and inflation. And then there are the effects of the higher cost of finance. The debt servicing of the federal government is continuously increasing whereas its effect is slightly offset by an increase in the profits of the State Bank and higher tax receipts from the financial institutions holding T-bills with higher rates of return. Almost all the businessmen are getting benefits from the various credit schemes of the commercial banks and slight change in their financial cost can change the economics of their order or project. In the last fiscal year, Pakistan's industrial sector grew at 8.4% against the target of 9.1%. And within this, the large-scale manufacturing sector grew 8.8%, far below the target of 13%. A major reason attributed by industry for this slowdown in industrial activity was an increase in the interest rates. Therefore, higher interest rates are also hampering the financial position of the exporters and business houses. It must not be forget that due to this, Pakistani goods may not compete globally.

Summing up, the effect of interest rate adjustments are notoriously difficult to gauge in advance. Neither the strength of the impact nor when the impact will be at its peak can be determined with any certainty. What can, however, be said is that the Pakistan's economy is now entering into an unknown territory. It is facing many challenges for instance, interest rates have been raised, the economy is growing but not at the same pace, the global prices of petrol have risen sharply while Pakistan has yet to follow, dollar is appreciating against rupee despite the fact that it is depreciating worldwide and top of that shortage of electricity. Therefore, it is hard to think of a positive role for interest rates in the presence of these issues. It is sadly expected that the Pakistani products will be further non-competitive globally in coming days and it is uncertain how the effects of the increases in rates which have already occurred will unfold over the period. Anyhow, most economists believe that it is a necessity to fix the inflation first while interest rates could again be lowered as soon as the goal of price stability is achieved.

TABLE A

KIBOR (INTEREST RATE)

MONTH

2001

2002

2003

2004

2005

2006

2007

2008

JAN

.

8.00%

4.20%

2.40%

5.19%

9.05%

10.26%

10.06%

FEB

.

5.00%

2.90%

2.10%

5.71%

9.23%

10.23%

10.29%

MAR

.

6.50%

2.40%

2.20%

6.28%

9.13%

10.13%

.

APR

.

7.00%

2.50%

2.20%

6.90%

9.37%

9.89%

.

MAY

.

7.00%

2.30%

2.42%

7.59%

9.32%

10.10%

.

JUN

.

7.40%

2.40%

2.66%

8.35%

9.20%

10.10%

.

JUL

.

6.00%

2.20%

2.93%

8.64%

10.37%

10.10%

.

AUG

.

6.50%

1.60%

3.22%

9.10%

10.03%

10.10%

.

SEPT

10.40%

6.60%

1.80%

3.54%

8.87%

10.06%

10.10%

.

OCT

10.50%

6.70%

2.20%

3.90%

8.94%

10.32%

10.10%

.

NOV

8.50%

6.50%

2.00%

4.29%

9.10%

10.29%

10.10%

.

DEC

8.40%

4.70%

2.40%

4.72%

9.20%

10.42%

10.10%

.

Source: State Bank of Pakistan