Good intentions mean little when policymakers start taking uninformed decisions or act on advices of experts with little understanding of the domestic economic dynamics. Blind man leading a blind man will end up falling in a pit.
The recent decision of MoF on interest rates setting in rising interest rates scenario for domestic debt based on theoretical "rollover risk" and untimely 're-pricing risk" seems to defy logic. There is no DG debt at MoF and the officials are probably responding to experts who have little understanding of domestic debt market mechanics.
The government last week accepted a tiny amount in fixed PIBs auction at high rates which sent distorted signals to the market. This was by far the highest gap in cut off yields between any two successive issues in the history of PIBs - the yield increased by 445 bps in Dec18 from last issuance at 8.7 percent in Jun18. The previous highest jump was in May 06 when the 10Y PIB cut-off yield jumped by 250 bps - there was a gap over 26 months between May06 and the previous issue. In 2018, the yield jump was double and time gap was a mere 6 months.
The move is unprecedented and is against the supposed slope of yield curve. In days of rising interest rate scenario, yields in short term paper usually increase more than the long term instruments with expectations of interest rates to move down much before the maturity of longer term papers. For instance, in May 2009, the yield curve was inverted - when 6M paper yields at 13.26 percent were higher than 10Y paper at 12.42 percent.
Back then, interest rates were on decline; they are not, today. But even months before that, the expectations of interest rates peaking had flattened the yield curve. Today, it is going in the opposite direction as the yield curve is getting steeper.
Such signaling would adversely affect the government domestic debt servicing cost. The government’s domestic debt cost has already gone up to disturbing levels and the higher PIBs cut off would further exacerbate the situation. The government domestic debt servicing as percentage of GDP in 1QFY19 (annualized) is highest since FY00.
Back in 2000, under the IMF programme, due to miscalculated NDA targets, banking overnight open market rates reached north of 100 percent on 31st Dec 2000. There are no parallels to draw; but the incompetency and lack of understanding at the time of negotiation with the Fund is a commonality
The reported reasons of accepting bond at higher rates last week described by MoF spokesperson are to reduce 'rollover' and 're-pricing risks'. Both premises are uncalled for. The rollover risk is essentially in foreign debt for Pakistan. In theory, the rollover risk is applicable for domestic debt with an assumption of capital convertibility which is not the case for Pakistan.
Any domestic debt retiring eventually would go back to government in one form or the other, unless it is used for imports or kept as currency. For instance, in case of retirement of T-bills, banks may extend the liquidity to private sector, but that deposit creation by private credit will either be consumed by government directly or be mopped by the SBP and in turn the SBP will meet the debt requirement of the government.
In a nutshell, the money in domestic system will remain there and will eventually feed to government’s fiscal deficit financing requirements, irrespective of rates and maturity. If the government stops borrowing, the liquidity creation in banking system will shrink as in modern monetary economics, the private or public debt (loan) creates money.
The only sane way of reducing the government debt creation and creating space for private sector, by systematically lowering the rates, is nothing but reducing the fiscal deficit. The problem today is that such high rates are making the fiscal deficit look uglier.
The other element of 're-pricing risk' holds true when the government is borrowing at lower rates (at the bottom of interest rate cycle) in short term papers. There is a risk of issuing papers at higher rates in subsequent auctions; hence, the government may prefer to lock in the long term paper to benefit at the bottom of interest rates, not at the top of cycle.
But the banks do not show interest in investing in long term fixed papers when the interest rates are low. That is why the MoF introduced floating PIBs - for details read "Debt profiling don't repeat 2014 mistakes" published on 24th December 2018. But any new instrument needs a buy in from market participants and a vibrant Debt Office at MoF, which is not the case today.
The adverse implication of accepting higher yield would be on government domestic debt servicing cost, long term investment and equity market. The players would be tempted to invest in NSS - for details read "More supervision required at MoF debt office", published on 28th December, 2018.
The bottomline is none of the indicators suggest accepting such high yields - be it inflation or oil prices; as all indicators suggest the interest rates will move down by 2019 end. The government should be careful in implementing ideas coming from its advisors and the IMF as the cost has to be paid by tax payers and economy at large.
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