DOUBLE-DIGIT INTEREST RATE FAILS TO CONTROL DOUBLE-DIGIT INFLATION

SYED FAZL-E-HAIDER
(feedback@pgeconomist.com)
Aug 8 - 14, 2011

Pakistan's central bank unexpectedly cut the discount rate by 50 basis points to 13.5 percent from 14 percent, almost three weeks after its governor Shahid Kardar resigned.

The central bank's decision to cut the policy rate came as a surprise to many analysts, who were not expecting reduction in interest rate.

Kardar, who stepped down as central bank governor on July 12, raised the policy rate to 14 percent in November 2010 and kept it unchanged for the past eight months to discourage inflation-fueling government borrowing.

His tight monetary policy however proved ineffective in weaning the government off State Bank funding.

The government borrowing rose 58 percent to Rs716 billion in the last fiscal year 2010-11 from the previous year, according to the central bank.

The double-digit interest rate has so far been unable to control double-digit inflation, which has become a serious problem for the country where up to 40 per cent of its 170 million population, live below poverty line.

The acting governor of State Bank of Pakistan (SBP) Yaseen Anwar announced the first monetary policy of the current fiscal year 2011-12 for the next two months on July 30 lowering the key policy rate on the expectations that inflation for the current fiscal year could drop to 11.5 percent.

He gave the average inflation as the rationale for the rate reduction, as he expected inflation to remain in line with government target of around 12 percent set for the current fiscal year.

"The key parameter in this assessment is the outlook for inflation, which indicates that average inflation in FY-12 is expected to remain in line with the announced target," Anwar told a news conference on July 30 in Karachi. "No adjustment in the interest rate would have entailed further tightening of monetary policy in real terms, which is not warranted given the decline in private investment."

He however said, "given an increase in debt obligations and continued suspension of IMF's Stand-By Arrangement (SBA), financing even a small external current account deficit could pose challenges in terms of maintaining an upward trajectory of SBP's foreign exchange reserves".

Consumer prices Index (CPI) inflation in Pakistan climbed 13.7 percent in July, which is the second-fastest inflation in Asia. Ironically, in the first month of the current fiscal year the government missed the inflation target.

It was the first cut in the discount rate since November 2009 when the central bank revised the rate downward by 50 basis points to 12.5 percent. Critics say that a meager drop in discount rate will make no difference as the rate is still one of the highest in the world, hence it should have been reduced by three or four per cent.

The country is still maintaining one of the world's highest benchmark interest rates, in an economy hurt by inflation, terrorism and falling foreign investment. Foreign direct investment dropped 26.8 per cent in the fiscal year 2010-11 to $1.573 billion from $2.150 billion in the same period last year.

High interest rate has been the key reason behind the low growth in the industrial production and closure of many industrial units.

In the last fiscal year, the manufacturing sector has seen only a three per cent growth. The tight monetary policy has not allowed the private sector to play its key part as engine of growth. High borrowing costs discouraged the demand for private sector credit, which in turn decreased private investment adversely affecting the prospects of economic growth.

The easy recourse to increased borrowings from the banking system leaves little incentive to the government to put its badly needed fiscal situation in order.

The government borrowing from scheduled bank grew 74.5 percent last year that contributed 65 percent to the 15.9 percent growth in broad money (M2), according to the central bank.

The drop in private sector credit was only four percent. As a result of the drop in tax-to-GDP ratio to 8.6 percent, the fiscal deficit for the fiscal year ended on June 30 is estimated at 6.2 percent of the GDP.

"The underlying reasons for growing government borrowings are structural and not specific to FY11, though it must be acknowledged that FY11 was a difficult year given the floods and other pressing spending needs," Anwar said.

Former SBP governor Kardar differed with the government over impeding the central bank's autonomy.

"The independence of a central bank is crucial, more so in challenging economic conditions," Bloomberg reported Saad Khan, a Karachi-based economist at Arif Habib Ltd. as saying. "The biggest challenge the new governor will face is to keep pushing for a limit on government borrowing and that may not be very pleasant for a lot of people."

Critics say that the resignation of two central bank governors and one finance minister since the start of 2010 exposes a breakdown in policymaking, threatening efforts to revive growth amid surging prices and terrorism in the country.

Soaring inflation has not only raised the credit price but also weakened the purchasing power of the people.

Though the central bank's tight monetary policy could not tame the soaring inflation, yet it did stagnate the economic growth.

The country's economy witnessed a growth of 2.4 percent in the year ended June 30, slower than an earlier target of 4.5 percent.

The inflation rate during the fiscal year 2010-11 remained over 14 percent. Local experts warn that the government's inability to control its increased borrowing for current expenditure may push Pakistan into a prolonged spell of stagflation.

A report recently issued by Topline Securities has forecast "inflation to stay in double digits in fiscal 2012 as well, it will be the first time in the country's history that we will observe double digit inflation for five years straight." "Pakistan, in recent years has been in the grip of high inflation, which amongst other things has adversely affected the economic health of the country," says the report.

International Monetary Fund (IMF) and Pakistan officials were due to meet last month but the meeting has been delayed. The meeting, scheduled in July, was aimed at releasing the sixth tranche of an IMF's 11.3 billion loan, which was held back last year over the country's inability to implement fiscal reforms.

IMF had conveyed to Islamabad during the last meeting with Pakistani officials in May in Dubai that the talks on the ongoing loan program would be resumed on the basis of actual and reconciled data. Previously, the IMF had declined a request to hold next review of the 'suspended' $11.3 billion standby program on the basis of estimated figures of expenditure and revenues of the last financial year.