WILL LOWER INTEREST RATE INFLATE THE ALREADY INFLATED ECONOMY?
Mar 30 - Apr 05, 2009
Finance advisor Shaukat Tarin has indicated that the interest rate, which was raised to 15 per cent from 12 per cent in November 2008 after agreement with the IMF, could be reduced to single digit in July-August. The interest rate was increased to bring the inflation under control and to bring a major fall in the monetary expansion, which was just 2.26 per cent during eight months of the current fiscal year against 7.36 per cent during the corresponding period of last year. Some bankers however believe that lower interest rate will hurt inflows of dollars in the country and inflate the already inflated economy. They believe that the possible discouraging effects on foreign inflows need to be considered before reducing the interest rates. The higher return has increased the inflows through remittances by 19 per cent. On the other hand, the open and inter-bank market has witnessed some stability due to the unregistered dollar inflows.
Businessmen are unhappy over the central bank's decision to keep the policy discount rate unchanged at 15 percent and fear that loan defaults will continue to mount and portfolio of non-performing loans of all banks will bulge to almost out of proportion limits. They fear that the banks' interest rate for a majority of businessmen is bound to touch 20 per cent mark, as KIBOR is a product of a cartel of selected bankers. The rates on which loans are given differ from client to client, as foreign companies with a privileged status enjoy a special rate.
IMF has linked the cut in interest rate to reduction in the core inflation (non-food non-energy), which was 18.9 per cent in February, on year-on-year basis, reflecting the seriousness of the inflationary pressure on the economy. In the last 18 months, the State Bank of Pakistan increased its benchmark interest rate five times to tame the core-inflation but it still remained at a higher side. It seems that tightening of monetary policy is not working as far as the inflation is concerned.
The decision of raising discount rate to 15 percent in November 2008 was also taken to abate inflationary pressures in the economy, according to some analysts. Consumer price inflation (CPI) had gone up by 25 percent and core inflation by about 22 percent during July-October 2008 as compared to the corresponding period last year. Food inflation was even higher at 34 percent, pushing a lot of people below the poverty line. CPI has fallen consecutively in November and December 2008 from a record high of 25.3 percent in August, 2008. Wholesale price inflation also witnessed a significant fall from 35.7 percent in August 2008 to 17.6 percent in December 2008.
The declining trend in inflation however could not gain momentum in the second half of the current fiscal year. Last month, the inflation rose after declining month on month for three months after hitting a record high of 25 percent last October. The spiraling food prices and weakening Pakistani rupee pushed up CPI inflation to an all-time high of 21.07 percent in February from a year earlier. Soaring inflation is hurting low-income groups disproportionately in the country and a common man is unable to meet the basic needs of life including food, cloth and house. The relentless surge in prices of essential commodities has eroded the purchasing power of middle and lower income groups in the country. The inflation has hit poor consumers harder than the more affluent ones, as for each one per cent increase in inflation, more and more people fall into poverty. The government has still not even ensured the provision of subsidized flour, pulses, meat and ghee to the poor. The poor are highly sensitive to the price changes in food, particularly staple food items. Households struggling to meet the minimum standards of living might have no choice but to cut down their expenditures on health and children's education.
The CPI in February was up 0.95 percent from January, according to the Federal Bureau of Statistics (FBS). Inflation had been falling since October raising expectations of a rate cut when quarterly monetary policy is announced next month. Consumer prices increased an average 23.49 percent in the July-to-February period, compared with a gain of 8.9 percent a year earlier. The rise in inflation in February is mainly attributed to an increase in food prices.
The businessmen say that the government's decision to keep the interest rate at 15 percent was illogical, as it has hard-pressed their business in the country. Critics contend that the government had agreed with the IMF to raise the discount rate by 350 basis points in two phases. As per its commitment, an increase of 200 basis points was mandated to be made effective before the $7.6 billion deal was approved by the Board of the IMF, while the rise of another 150 basis points would be dependent on the behavior of relevant indicators this fiscal year. In order to regularize a precondition to enter the IMF programme, the critics say, the central bank had announced a two percentage point increase in the bank rate last November. The country was forced to yield to the IMF conditions to get its assistance due to the rapidly dwindling foreign exchange reserves and the fear of default on foreign payment obligations.
Reduction in discount rate by 200 basis points would be essential to provide relief to the ailing industry and trade. During the Pakistan-IMF talks in Dubai last month, the two sides have reportedly agreed to revise discount rate in line with the decline in inflation. The analysts believe that the economy needs reduction at least by 200 basis points, as the cut in discount rate by 100 basis point or 150 basis points would not have positive impact.
Critics say that irrationally high interest rates and tight monetary policy of the central bank is holding back the growth and expect a GDP growth of less than 2 percent, lowest in 10 years, in the current fiscal year ending June. Pakistan's high-growth episode of 2004 to 2007 was the result of a growth model based on misguided policies, the Asian Development Bank (ADB) pointed out in its recent report titled "An Analysis of Pakistan's Macroeconomic Situation and Prospects". The current account deficit, the report says, resulted from imports increasing faster than exports, which led to dependence on inflows of overseas remittances, FDI, portfolio investment and loans. Increased government spending, together with an increase in business confidence, crowded in the private sector, with investment running ahead of savings.