Reverting to the basics

The State Bank of Pakistan, it seems, has finally decided to make the right move. After dithering for a while, it has realised the necessity of raising the interest rate structure in the economy in order to contain the emerging inflationary pressures. As a clear signal to the market, it sucked in more liquidity from the money market than it had targeted, and in doing so also substantially increased the yield offered on TBs on the 1st of September, 2004.
A target of Rs 50 billion had been fixed for the auction but the State Bank accepted a much higher amount of Rs 61.055 billion in order to drain the market of excess liquidity and reduce the credit creating potential of the banks.
As regards the rates, Rs 54.256 billion were raised from the three months TBs, hiking the yield by 0.4816 percentage points from 2.1853 percent to 2.6669 percent, and Rs 6.798 billion were mobilised from 12 months TBs by pushing the yield by 0.3084 percentage points from 2.8355 percent to 3.1439 percent.
In the last auction also, the State Bank had increased the weighted average yield on three-month and one-year bills by a considerable margin.
Considering the recent trends, the increase in the yield during the course of the year could be quite substantial, indicating a departure from the easy monetary policy stance followed during the previous years.
The shift in policy is not without sound reasons. Inflation, after remaining subdued from 1999-2000 to 2003-04, is clearly moving upwards and the recent price indices released by the Federal Bureau of Statistics are undoubtedly a cause of great worry. Consumer Price Index (CPI) in July, 2004 was higher by 9.3 percent compared to a year earlier and the data for August likely to be released in the second week of this month is not expected to show a much different trend.
Average households who actually feel the heat believe that inflation is even higher than indicated by the rise in official price indices.
The State Bank's attitude was, however, pretty relaxed on these developments. In its monetary policy statement, the Bank had indicated its intention to gradually raise the interest rates and actually adopted this course of action for some time. Yet it was reluctant to make a major move, fearing that a sudden rise in interest rates would clamp economic recovery.
The sharp rise in TB yields during the last two auctions, however, clearly suggests that inflation is now the central bank's top priority and it may be prepared to take more measures to contain inflationary pressures.
This realisation on the part of the State Bank is definitely welcome. We have been suggesting such a shift in strategy and urging the State Bank to be more pro-active in combating the rising risk of inflation because it could make the lives of ordinary people more miserable and may be harmful for the economy in the long-run.
An appropriate rise in interest rates would, besides containing inflation, also tilt the balance in favour of savers and bring a much needed sense in the real estate business.
The upsurge in the shares market could also lose some steam. However, while welcoming the move, we are also conscious of State Bank's difficulties in this respect.
The surplus liquidity in the market generated mainly through the inflow of foreign remittances amounting nearly to Rs 230 billion cannot be easily drained and interest rate forced to increase when the country is committed to the free interplay of market forces and the government's requirements for budgetary support are not substantial.
Also, the lobby of entrenched chambers of commerce and industry has to be kept reasonably satisfied. To revert to the basics, ie raising interest rates to counter inflation against these odds may not be easy but, in our view, is essential to sustain public faith in government promises and policies. It is particularly in this vein that the State Bank should be prepared to use every instrument at its disposal to meet the inflation target of 5.0 percent promised to the nation at the beginning of the year.
The present hike in TB yields seems to be only the first step in that direction.