HIGH INTEREST RATE CROWDING OUT PRIVATE SECTOR
TARIQ AHMED SAEEDI
Aug 16 - 22, 2010
In its latest monetary policy, State Bank of Pakistan scaled up the discount rate by 50 basis points to 13 per cent in order to rein in inflation contrary to the expectation among business community that the central bank would maintain the policy rate at its level or revise it down. The main reasons behind this push, according to the central bank, were persistence in inflation -average consumer price index inflation of 11.7 per cent in financial year 2010 stood at 2.7 per cent percentage point higher than the target- and anaemic economic recovery. And since CPI inflation is projected to stay in between 11 to 12 per cent throughout the current fiscal year, more than the target of 9.5 per cent, there is a likelihood of strict policy for the next monetary policy announcements to be unveiled.
As always, business community expressed strong criticism about the hike in policy rate terming it investments unfriendly and harmful to industrial productivity, which is already under strains owing to energy crisis. High cost of funds increases the project cost and therefore dissuades investors to embark on industrial expansion. The present rise in discount rate has already reflected in up in Kibor in between 40 to 50 basis points at the beginning of this month. Inter-bank operating rate for six month, one and three years saw a surge in proportion to discount rate increment.
Local industries are slowly losing its global competiveness because of high cost of production. Electricity and gas tariffs are all time high besides inconsistent energy supply is marring the production quality. Under pressure of rising cost of inputs and disturbed law and order situation, which get foreign clients shifted their export orders to other countries, local industries are also moving to competitive countries like Bangladesh. Liquidity crunch also sours investor's sentiments to take initiatives locally. When funds from banking system get expensive, borrowers from both public and private sectors are disappointed.
While public sector or government normally utilises borrowed money to fill revenue-expenditure fissure, such funds always add value to industrial productivity when directly used by the private sector. In an event of rate hike, economic activities receive a major dent. For real GDP growth, interest rate should be kept on affordable level as what other countries do.
Generally, government borrowing from State bank or scheduled banks is considered highly inflationary. And whenever net domestic assets of the banking system assume higher proportion over net foreign assets, central bank resorts to discourage money outflows through tightening monetary policy. Pushing interest rate is a common tool in Pakistan to do this although cash reserve and statutory liquidity requirements are as effective in many comparable countries. Neighbouring India witnessing boom in economic growth uses CRR or SLR mostly to control monetary momentum in its economy. In FY10, net domestic assets of the Pakistan's banking system linger at somewhere around Rs488 billion though government retired over Rs50 billion debts till the start of August. Government turns to banking system to support budget and to meet shortfalls in tax collection as well as in external financing.
In last fiscal year both from internal and external fronts, government could not generate required funds to maintain macroeconomic stability. The actual recovery at the end of last fiscal year was Rs253 billion less than budget estimate only on account of tax collection and external supports. Firstly, tax collection was Rs53 billion less than the target and secondly government could not receive Rs200 billon pledged by foreign sources and factored in the budget 2010. Because of this, not only government borrowing crossed the predetermined limit, but macroeconomic plan also got upset.
Fiscal deficit for the year reached beyond six per cent of gross development products and this rate was not only above than the target but also poses risk to macroeconomic stability. Even for the current fiscal year, fiscal deficit is projected to linger around the similar percentage points. It is notable this projection was made when flood was not there. After all, the devastation flood wreaked across the country particularly rural economy will call for significant spending on developments.
Various assessments are emanating out of local and international analyses, but real picture will become clear once the flood subsides. According to the United Nations, six million people have become flood victims. Only counted deaths reached in thousands. Flood has destroyed the infrastructure needed to provide facilities to public and industries. Electricity supply network in many flood-affected areas broke down. Roads, bridges and other physical infrastructure were damaged. Losses to agriculture sector are immeasurable at the moment, but initial estimates say near 150,000 square kilometres of lands have been affected by the flash floods. To understand the gravity one should refer to the statement of Prime Minister Syed Yousuf Raza Gilani who says Pakistan or the economy takes a retreatment of decades because of the flood. Billion of rupees will be required to bring affected areas back to the normal conditions. Under such circumstances, pace of mobilising internal and external funds ought to be accelerated to prevent economic instability. Widened fiscal deficit will imply crowding out of private sector since government's reliance over borrowing for infrastructure developments will keep upward pressure on interest rate. Keeping private sector at distance may exert impact on export performance and thereby enlarging current account gap. However, implementation of austerity measures in their essence will create internal sources of funds. Government also needs to make tax administration system efficient to minimise incidences of tax evasion. There is a need to revisit the concept that high interest rate can control CPI inflation. In Pakistan's case, it has never happened. Nevertheless, calibrating interest rate may encourage or discourage borrowing.