The interest rate conundrum

The twin deficit is growing and so is the component of external financing. The fall of reserves has been tapered off as probably government has decided to live on short term borrowings before the authorities decide to go to the global debt capital markets.

The reserves came down from the peak of $24 billion in Oct16 to $19.9 billion by second week of Aug17. And the toll is up by $300 million in the last three weeks. The current account numbers of August are not released as yet; the deficit surely would be high, albeit, it may be lower than $2 billion registered in July. The home remittances recorded at $1.9billion in August which is the highest monthly inflow since Jun16.

Anyhow, the trade deficit, according to PBS data, is up by 16 percent (yoy) in August. Thus, the reliance of external financing is the only way to keep the reserves north of $20 billion.

In the previous years of PMLN government, the net government external borrowing was not much as the fiscal deficit was not out of control. But now the government is losing the grip- the net external fiscal financing was Rs181billion in FY15 which increased to Rs371billion in F16 and in FY17 the toll reached at alarming levels of Rs541billion. The number may inflate further in FY18 as development spending close to election ought to be high.

The government borrowing has remained high in the past few years with higher reliance on domestic banking sources followed by external borrowing. Since, the interest rates are low, both in domestic economy and globally, debt servicing cost has remained in check. But with ballooning twin deficit at home, monetary tightening is becoming the only choice for policymakers at home.

But that would have an adverse impact on debt servicing cost which would further inflate the fiscal deficit. The argument is similar to currency depreciation which would increase the foreign component of debt servicing. The foreign debt servicing is mere one tenth of total debt servicing cost of Rs1.38 trillion in FY17. This is implying that raising domestic interest rates has higher fiscal cost than that of currency depreciation.

But politically, it is easier to swallow higher interest rates than currency depreciation. The question is that whether the policymakers would tighten the monetary policy to curb the demand or not. Any policy adjustment would have fiscal implication in immediate terms, and government is apparently not looking beyond 2018 elections, if they are at all concerned on economic fundamentals. Perhaps, the finance minister is too occupied with NAB cases at the moment.