Dec 7 - 13, 2009

When the interest rate is pushed upward, the banks take it as a signal that the SBP, through its tight monetary policy, intends to control credit and money supply to contain inflation.

The overriding objective of achieving price stability decrees a trade-off between money supply contraction and growth. With every alteration in the rate, the inter bank borrowing rate KIBOR is also altered, usually in direct proportion. The banks' short and medium term lending rates, which are linked to KIBOR, are also adjusted accordingly.

Money supply is contracted on one hand, but the output and employment levels drop on the other. High interest rates increase the cost of doing business, especially in the real sector, rendering the products uncompetitive in the external markets. This puts pressure on country's exports.

The problem with focusing on interest rate is that the growth rate of money and inflation often tend to increase. A moderate money growth is the only option to avoid inflation in the long run. Unless propped up by strong administrative support, the policy of using interest rate to achieve price stability in the developing economies like Pakistan can hardly be relied on.

With our interest rates being the highest in the region, the negative growth of around 8 percent in the LSM sector during the FY09 did not come as a surprise to many.

Being in a capital intensive and highly leveraged sector, the large-scale manufacturers could not afford high-cost credit. Banks normally lend at a rate that is few percentage points above the 6-month KIBOR.

During the 15-percent policy rate regime, the cost of borrowing used to be as high as 20-22 percent. This unfortunate economic scenario was in sharp contrast to the global economic scenario where efforts were on to ward off the violent recessionary forces with the help of frequent and substantial rate cuts.

Table showing 6-month KIBOR vis-a-vis SBP interest rates
04-12-09 12.41 12.50 26-01-08 15.65 15.00
07-10-09 12.66 13.00 07-10-08 14.92 13.00
21-08-09 12.32 13.00 17-09-08 13.97 13.00
25-02-09 13.98 15.00 13-08-08 13.50 13.00
14-01-09 15.57 15.00 07-07-08 14.07 12.00
31-12-08 15.70 15.00 18-03-08 10.36 10.50

Inflation and unemployment are the ultimate targets of central bank's policy. Interest rate and the rate of growth of money and credit are the intermediate targets, which the central bank can aim at. Inflation targeting is widely popular with the central banks to achieve long-term objective of price stability.

The disadvantage of this approach is however, quite considerable as it restrains central bank's ability to control fluctuating output and employment levels.

In the event of an adverse supply shock, which raises prices and reduces output, inflation targeting may force the central bank to check money supply at a time when the economy is in recession. This is exactly what happened in our case.

SBP had to intervene with successive rate hikes at a time when the economy had already taken a downturn due partly to global economic factors and partly to our home-brewed political and financial crises, which saw massive capital outflow. Under the then prevailing circumstances, the SBP thinking was quite clear that even if the interest rate increase adversely affected growth in the short term, the primary concern would remain the check on inflation.

The combination of a high interest rate and a depreciating rupee contracted economic growth considerably in FY-08 and extensively in FY-09 when GDP rate came down to 4.1 and 2 percent respectively.

While the effect of a high rate regime on domestic economy may be debatable according to the inflationary conditions, its effect on import-oriented external economy is always depressing. A substantive fall in import bill in FY-09 should not be erroneously attributed to a high policy rate and the so-called contracted money and credit supply. Rather it was more the outcome of a steep fall in international oil prices and gradually falling food and commodity prices.

The combination of the above-mentioned two factors produces a mixed effect on exports. Exports are depressed because of increased cost of business, but the depreciated currency unit acts as a stimulus for the export business. In our case, the exports of traditional items registered a decline, while the exports of non-traditional items picked up.

We maintained a rising trend in exports until 2007-08 but witnessed a fall of 6.7 percent in the next fiscal. It was on an average 30 percent depreciation in rupee value that prevented a drastic reduction in the size of exports. With the gradual downward adjustment in the policy rate- from 15 to present 12.5 percent- and improvement in the overall domestic and international economic scenario, our exports have started to pick up during the current fiscal.

The effect of a high interest rate and a depreciated currency unit is two-fold on the real sector economy. The effect of these two factors is not so profound on the service sector economy. The enhanced role of service sector in sustaining the external economy even during a high interest rate regime calls for effective policy measures to ensure further boost to this fast growing sector.

During recent times, the global service exports have registered tremendous growth. Regretfully, Pakistan has a negligible share in the world service exports- just 0.12 per cent in 2007. With huge potential in our banking, insurance, and IT sectors, this minuscule market share would appear highly disappointing.

The TDAP initiative to act as a facilitator between the service sector and the concerned ministries and divisions is a welcome step. This sector needs still greater attention in the shape of effective and resourceful private-public partnerships. This sector has the potential to outperform certain top categories of the real sector on external side of the economy.