HIGH FINANCIAL COST
AROOJ ASGHAR (Arooj.email@example.com)
Oct 26 - Nov 01, 2009
The unusually high cost of financial intermediation in Pakistan, as measured by the reported difference between bank lending and deposit interest rates, is a major source of concern. Pakistan is one of the few countries in the world that reports average spreads above 300 points. The phenomenon of high interest rate margins has had a long history in Pakistan.
Pakistan is not alone in having had very high inflation in the past and having reduced it to slightly above the single-digits. The high level and persistency of spreads has become an important source of concern for Pakistan's policy makers and researchers. High spreads are much more than a nuisance to the conduct of the business. This means high, and often more volatile lending rates, leading to a higher cost of capital, reduced investment, and a bias towards short-term high-risk investments, away from long-maturing investments with higher social returns.
Moreover, high banking spreads can disproportionately hurt small and medium enterprises and encourage informality. More generally, high spreads can be interpreted as a symptom of a poorly functioning financial system, which can hinder economic growth. Although the issue of high banking spreads has received much attention, major gaps and puzzles remain there.
Macro factors play an important role in the determination of spreads, as there is a systematic relationship between the level of the basic interest rate and the width of the intermediation spreads, magnified by costs, leverage, and default risk.
In fact, Pakistan's economy mostly moves independent of other regional economies. The economists point out that the State Bank of Pakistan over reacted to inflationary pressures that resulted in very tight monetary policy. High inflation can be due to high petroleum and food prices. As a matter of fact, petroleum prices remain high in Pakistan irrespective of international trend consequently impacting negatively other commodities. It is said that India touched almost double-digit growth due to low interest rates. Later Reserve Bank of India gradually tightened the screws and by September 2008, it increased the policy rate that slashed the growth rate to five percent.
It is also said that Reserve Bank of India later realized its mistake and gradually lowered policy rates rapidly when the inflation started receding. SBP increased its policy rate to a peak of 16 percent in November 2008 on inflation of 25.3 percent in October 2008. The inflation receded to 10.5 percent but the policy rate has declined by only 3 percent. The high interest rates have dried out the appetite of the private sector for bank credit.
The industrial growth in Pakistan is still declining. Agriculture continues to be the main source of GDP growth. On one side, industry is suffering due to lack of electricity and on other high interest rates are affecting financing cost of the business.
The policy rate in Pakistan is 13 percent on inflation of 10.5 percent while it is 3.5 percent in India on inflation that is touching 8 percent. India has higher inflation due to high food rates and they know that monetary policy cannot control inflation caused by high food rates.
Pakistan has a history of high rates. Former caretaker Prime Minister Moin Qureshi had raised the interest rate to 23 percent and the banks made it up to 30 percent. He thought he would be killing inflation through that means which he could not. But, the hope of low inflation and low interest rates (except for brief periods) is illusory.
A change in the interest rate remains in the limelight by the policy makers both in the public and private sectors, as it influences the cost of business through financial cost. Certain sectors of the economy seem to be highly leveraged, as their assets are financed by debt rather than own equity. Before a change in interest rate is made, there is a need to estimate the capacity of the overall corporate sector to withstand the resultant impact.
Working on each sector's financial leverage as how much debt is used by each sector to transact business and whether an increase in interest rates is going to hurt the business activities or a decrease in interest rates would facilitate a positive change is important.
As a matter of fact, textile is not the only sector in Pakistan which is affected by this phenomenon. Because of high interest rates, stock market also performs below to its full potential. The private businesses also form part of the overall economy, whereas one must consider the listed sector for analyzing economic impact of raising interest rates, and each sector's leverage ratio may be judged on the basis of its size and whether such sector has a greater or lesser proportion of private entities.
Interest rates affect the economy slowly. When SBP changes the Fed Funds rate, it can take 12-18 months for the effect of the change to percolate throughout the entire economy. As rates increase, banks slowly lend less, and businesses slowly put off expansion. Similarly, consumers slowly realize they are not as wealthy as they once were, and put off purchases.
As far as the affect of a change in interest rates is concerned, empirical evidence shows that textile is the most vulnerable sector of all with 25 percent of the total economy's debt is used to finance its transactions. Furthermore, this sector has a high financial leverage ratio of approximately 10.4, which means that this sector has little breathing space and an increase in interest rates would further aggravate business problems and the cost of doing business would shoot up.
Apart from ghee and edible oil sector and shoes and leather, that shows a very high financial leverage of approximately 20.39 and 44.08 probably due to a larger proportion of debt being given to private entities and few companies are traded on the bourses, cable and wireless, automobile, textile and sugar and allied sectors depict a high financial leverage.
High interest rates keep on holding up industrial investment in Pakistan whereas alternate solution to the investors is to go to stock market to raise the requisite capital. However, under current circumstances it is also not possible by the present or prospective investors to approach stock exchanges.
With continuous depreciation of Pak Rupees, high imports to export ratio and increasing trade deficit it seems that there is a need to bring down interest rates in the wake of controllable inflation. With a decrease in interest rates, there will be a possibility of increase in economy's production.