Ominous signs of a rate cut

Back in 1996, Ahmed Mukhtar who was the Federal Commerce Minister at the time, publicly advocated reductions in interest rates. Soon after his statement, the central bank began to cut rates. Mukhtar, who is now the Federal Defense Minister, was quoted last week as having said that interest rates should be down by two to three percent in the near future. He also contended that the President agrees that rates should come down, significantly and soon. Not to suggest that Mukhtars premonitions have any bearing on the monetary stance of SBP, but the writing is on the wall. NSS rates were revised down by 0.5 to 0.96 percentage points on different instruments, last week. Cut-off yields on T-Bills also fell by 48 basis points on one-year paper in Wednesdays auction. T-Bill rates have reacted to changes in the discount rate by SBP in recent months but this time around markets seem to be jumping the gun; anticipating the central banks decision prior to its formal announcement. The fact that the commercial banks have agreed to the governments proposal of conversion of floating debt from the power and commodity sectors into fixed-tenure government papers, at rates below those offered under a similar deal some months back also hints at expectations of a sharp decline in interest rates in coming months. So, does this entire ruckus over rates warrant a sharp decline in the discount rate tomorrow? The answer is a big NO! There is no doubt that inflation is coming down and that the external balance has shown resilience; thanks to the strength of the current account. But inflationary expectations are still intact and caution has to be the order of the day. According to a working paper prepared by SBP, formal firms are more sensitive to cost of energy and intermediary inputs and exchange rate in setting up prices. These firms adjust their own prices 2-4 times a year, causing a cascading effect on other prices. The local currency remained volatile against USD last month, especially in the open market and the central bank had to intervene to cool the market. Still, the rupee has depreciated by 0.8 percent since the start of this fiscal year. The other variable: energy prices also have to be adjusted frequently under tariff rationalisation regime. On the demand side, running a high fiscal deficit exacerbates risks of higher inflation and in the absence of any material effort to increase taxation, reduce subsidies and plug the bleeding public sector enterprises; the fiscal deficit is not likely to come down any time soon. Add to this the conversion of Rs.400 billion worth of quasi-fiscal operations lending into government papers and you end up with a hefty increase of 2 percent of GDP in the fiscal deficit. Foreign financing for the fiscal deficit is largely lacking. Relations with the US are headed south and the eurozone crisis has other traditional donors with deep pockets, tied up elsewhere. Hence, the onus of deficit financing falls squarely on domestic sources. Within the banking sector, government borrowing has reached Rs.237 billion in just over a quarter in this fiscal year alone. Virtually, all of this borrowing has been from the commercial banks. Summarily put, crowding out of the private sector continues unabated. However, note printing presses have finally been given a much-needed respite in recent months. Still, given the lack of private sector demand coupled with the banks reluctance to lend; it appears that a cut of 50-100 basis points, while likely will not serve to spur demand adequately.