HIGH INTEREST RATE: A THREAT TO ECONOMY
Mar 30 - Apr 05, 2009
Shaukat Tareen, finance advisor said that by the end of the current year inflation rate would drop below 10 percent that automatically brings down the interest rate to an average 4-5 percent in one year, which is currently standing at 15 percent. Economists say that it will be too late to start with medication of a sick economy. Interest rate hike has already halted countryís economic growth, which reduced to around 2 percent.
Worldwide, there is trend of trimming policy rates. USA for example slashes the rate for discounts and advances to 0.5%, Bank of England reduces bank rate to 0.5%, Bank of Canada lowers overnight rate to 0.5%, and Australia pulls down rate to 3.25%. Also emerging market economies (EMEs), Korea, Indonesia, Thailand, Chile, and Mexico have reduced their policy rates. Reserve Bank of India has decreased the repo rate to 5.5%. As compared to these Pakistan seems the only country with such a high interest rate in double digits.
The impact of the internal and external driven economic crises may be intensified by the extraordinary high interest rate in an environment of rising global commodity prices, such that the tradeoff for the policy makers was no longer just between growth and inflation but also between monetary and financial stability, both of which require an equal and opposite policy reaction under the circumstances.
Therefore there is a strong need to understand the links of various macroeconomic indicators with interest rate changes. Higher interest rate implies a higher "price" of loan-able funds. The private sector, which is very sensitive to interest rates, will likely reduce investment due to a lower rate of return. This is the investment that is crowded out and weakens the fixed investment and other interest-sensitive expenditure.
More significantly, a fall in fixed investment by business can harm long-term economic growth of the supply side, i.e. the growth of potential output. The degree of investment depends on the relation between the rate of interest and the marginal efficiency of capital.
A great deal of the discussion has been carried out in terms of the federal funds rate. In reality, there are a large number of different rates: the rates on federal funds, Treasury bills, notes and bonds, commercial bank loans, mortgages, etc. Hence, the array of credit market assets should be divided into those that are closely related to the discount rate and those that are less closely related to it.
Financial Stability Review (FSR) 2007-08 of State Bank of Pakistan revealed that the efforts to expand consumer finance portfolio by banks are mainly faced with challenges originating from the less than favorable macroeconomic environment and emerging deterioration in economic fundamentals i.e. rising inflation rate, a certain degree of slowdown in economic activities, etc.
This weakness is further intensified by rising interest rates as a consequence of monetary tightening by the central bank which, besides discouraging new customers, has also made the existing debt servicing more costly for most of the loans that are made on a variable or floating rate basis.
An indication of the manifestation of the macroeconomic environment on consumer finance has already started to reflect in the deceleration in its growth rate, and a relative increase in non performing loans.
After two-third attrition in Pakistani market capitalization since April 2008, stock prices across various sectors certainly look very attractive on the basis of price earning multiples, price to book value and dividend yields.
However, expectations of quick rebound in share prices are quite muted in the wake of sharp reversal in economic growth and visible signs of fall in corporate sector earnings. Moreover, a massive plunge in stock prices, which has evaporated over $40bn of wealth, has created a big vacuum that is not going to be replaced with new liquidity soon.
Therefore, the stock market is expected to see many more months of consolidation at lower levels before things start improving at the macroeconomic front. Depressed stock prices normally reflect fear about future and market concerns about the underlying business. The fear which is dominating at this stage is the state of the economy which is on the downward spiral with GDP growth slowing to record low levels in 2009.
Besides the domestic factors (high inflation, energy shortages and infrastructure bottlenecks), international economic crisis is now having a serious impact on Pakistani economy.
Under these circumstances, there is a need to look for some other answer to inflation spike then interest rate as it is badly hurting output growth. Other tools of monetary policy like open market operations (OMO) may be more effective than increasing interest rate. The SBP has decided that the monetary policy will be reviewed each quarter with the next statement to be expected at April end. A wise and pragmatic decision is expected regarding interest rate immediately.