IMPLICATIONS OF HIGH INTEREST RATE
SAAD ANWAR HASHMI
June 18 - 24, 2012
International oil prices continue to be volatile and are not expected to come down from $100 per barrel since high oil prices mean higher gross domestic product (GDP) of oil producing countries. Inflation in Pakistan has remained in double digits and is not expected to decrease to single digit. The core cause of concern for state bank of Pakistan (SBP) is government borrowing that is puffing up persistently. If oil prices decrease, this is negated because of devaluation of rupee against the US dollar. Consumer price index (CPI) as on May 2012 stood at 12.30 per cent with electricity, fuel and gas accounting for 29.41 per cent of the CPI.
SBP has kept the policy rate at 12 per cent in the latest monetary policy. During the first eight months of FY12, the external current account deficit was three billion dollar while the net capital and financial account receipts were only $187 million. A source for liquidity pressures in the economy is sluggish economic growth and foreign direct investments, which could substitute low tax base. SBP stressed the government must devise fiscal and energy sector reforms and plan foreign financial inflows to mitigate uncertainty and pressure on reserves.
During the current year, the government has borrowed Rs373 billion from the scheduled banks for budgetary support, bringing total public debts to Rs1,660 billion. The year-on-year growth in the private sector credit was only 4.2 percent. Since government securities yield a healthy risk free return, banks continue to prefer financing the fiscal deficit through investment in fixed income securities rather than focusing more on taking risk and extending private sector credit, which slashes investment to GDP ratio.
With slowdown in economic growth, it is believed there is no demand coming from the private sector for long-term investments, which makes it viable for banks to invest residual deposits in fixed income securities consequently resulting in crowding out of private sector and eventual rise in lending rates. It is difficult to ascertain the total demand of credit of consumers and private sector. The demand for credit primarily depends on demand and supply forces and internal lending policies of banks.
The competition in the banking sector is intense with smaller and midsized banks pulling deposits from larger banks offering competitive and attractive rate on liability products. The central bank, time and again, has encouraged banks to provide a healthy return on its depositors whereas banks strive to lower the rate of return, which in turn, increases the banking spread to improve profitability.
Since the return on deposits is a cost to a bank, in an ideal situation, no bank would like to incur this cost by squeezing the spread. Due to low returns, depositors find alternate mediums for investment such as national saving certificates, mutual funds, and stocks.
In order to help counter inflation and provide depositors with healthy return, SBP has been encouraging depositors to put their savings in government securities through investor's portfolio securities (IPS) accounts.
In May 2008, SBP introduced a minimum five per cent floor on all categories of saving products. Consequently, average deposit rate of all saving related products increased from 2.1 per cent to 5.25 per cent with no significant change thereafter.
The saving deposits of banks account for 38 per cent of all bank deposits and 52 per cent of total number of deposit accounts. As per SBP expectations, if depositors shift their savings from banking to alternate modes, the market forces will induce banks to increase their deposit base. The people who would be impacted the most are those who have low savings such as retirees who need an additional source of revenue through high rate of return.
Keeping with the stance to assist small savers, SBP increased the minimum return to six per cent on PKR saving/PLS saving products. The challenge for SBP with regard to monetary policy is to reduce inflation and encourage private sector lending alongside an attractive rate of return for depositors to counter rise in inflation. The monetary policy cannot work in isolation considering external shocks e.g. international oil prices, recessionary impact, devaluation in interest rates or government borrowings. Pakistan is a net importer. Therefore, any devaluation in the exchange rate against the dollar will make imports expensive and put further pressure on the reserves. Though exports due to such devaluation are expected to grow, considering rise in input cost, such differential may be negated making prices unattractive for the export markets.
An encouraging sign for the economy is overseas workers remittances, which reach an average one billion dollar a month. However, foreign direct investment (FDI) has decreased and is expected to be less than one billion dollar due to deteriorating security environment and policy uncertainty.
In order to curtail inflation and finance government budgetary deficits, SBP's decision on the monetary policy alone cannot work in isolation unless such policies work hand in hand with fiscal decisions to increase tax base and eliminate transactions, which run parallel to the economy.
The government's total expenditure to GDP is 19 per cent whereas revenue to GDP is 12.5 per cent creating a mismatch, which needs to be addressed by expanding tax base rather than borrowing from the banking system. What will eventually help in resolving the situation is high degree of integrity to address every challenge facing the country.