Monetary policy committee meeting is due on Monday. Majority of market participants expect no change. The SBP is keeping real interest rates in negative territory based on existing and FY21 projected inflation of 7-8 percent. Negative rates in Covid days is now a norm globally, aimed to generate monetary stimulus.
Some say that inflation is not a concern and there is no harm in generating further stimulus; but things are not that simple for a country where dollarization (formal and informal) is a concern with thin foreign exchange reserves. The other issue is to find buyers of government papers in days of negative rates.
To lure buyers towards PKR fixed assets, certain threshold of low rates is imperative, and that holds true for enhancing private savings. And to keep businesses’ interest cost low, central bank can increase its pie of concessionary financing schemes. This concept of dual interest rates is picking up around the globe. SBP is deploying this strategy with overwhelming response from businesses.
The SBP has slashed the policy rate by 625 bps since March-20. Its impact is now becoming visible. Asset classes such as equity and real estate are picking up. New wave of investors is getting into the markets. At the same time, interest in government bonds is fading. Low rates, fiscal stimulus, construction amnesty scheme, and falling Covid cases have changed the sentiments. The feel good factor is generating economic demand. An economy plagued with structural impediments can overheat in no time. It is better to tread with care.
Proponents of low rates are asking to give further stimulus to leveraged businesses – mainly for working capital. The advocates are mostly businesspersons themselves. Others say that this will save government budgetary spending on debt servicing. But not all government debt is repriced every 3 months; the equation is not that simple.
Moreover, rerolling of government debt is becoming a problem at current rates, as market is willing to participate only in 3- and 6-month papers, if the Debt Office (in Ministry of Finance) wants to keep cutoff yields unchanged. The secondary market yields are on the higher side. Some market participants are reading recent PIB auction results wrong.
They are of the view that phenomenon of lower cut-off yields than secondary market yields implies that market is expecting a rate cut or the ministry is of the view that there should be further loosening. However, market behavior is showing that rates may increase within 12 months and that is why participants are bidding at higher rates. For example, in last T-Bill auction, market offered Rs152 billion in 12M paper while government accepted a mere Rs225 million to bring cut-off yield down to 7.15 percent. The story of PIBs is similar.
Government is disregarding the auction targets. Debt Office perhaps could be of the view that inflation might be coming down in the next few months and market would adjust accordingly. The banks may come to the level that which government believes is right. The Debt Office could be of the view that policy rate maybe slashed further. On the other hand, market could be of the view that inflation may increase within 12 months and there might be a case of hike in rates.
But the market and Ministry of Finance are not decisionmakers. They both are market players while the decisionmakers are monetary policy committee members. The committee should make a call based on fundamentals. The story of fundamentals is that further rate cuts could be counterproductive. Dollarization is growing. FE25 deposits have grown from $6.1 billion on 13th March to $7.2 billion as of 4th Sep. During this time, interest rates fell by 625 bps.
The other issue is of IMF programme which is stalled. To get the Fund programme rolling, resolution of circular debt is important. In other words, energy – electricity and gas tariffs must be revised upwards. The concessionary budgetary funding of ADB and WB is contingent upon the continuation of the IMF programme. Last IMF report came in April and its validity is six months. Ministry of Finance carries the apprehension that without IMF’s fresh report, other multilaterals may halt the disbursements. It is a problem for deficit financing as market is already not keen to participate at low rates. If interest rates are reduced further, the government will struggle to finance its deficit. It might have to sell assets at low price. That is not a good option.
For IMF progarmme to get rolling, energy tariffs might have to increase. Power sector cost (generation) and losses (T&D) reduction plan is in the making. Once the plan is accepted by the IMF, the need to increase tariff would be reasonable. What is reasonable and what would be its impact on inflation are questions that SBP does not currently have information on, only projections. And MPC should wait for these answers before making a call on rates.
Having said that, inflation is on a downward trajectory. Core inflation is already low. External position is not vulnerable in the short to medium term. There is no reason to increase rates. SBP would do well to wait for more information to come out.
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