EDITORIAL: The SBP (State Bank of Pakistan) is scheduled to announce its monetary policy on 4th April. According to a seemingly credible survey, 93 percent of participants expect rates to increase by 100 bps (basis points) or more, and within this set 70 percent expect an increase of 200 bps or more.
The market yields have already incorporated an increase of at least 100 bps with the last cut of yield of T-bills close to 22 percent with policy rate of 20 percent and discount rate of 21 percent.
The question many have is about the efficacy of an increase in interest rates, from current levels, to manage inflation. That is a very pertinent question. The following are some questions that also need plausible answers:
Would a further increase in rates curtail inflation through demand management where inflation is primarily coming from the supply-side factors? Can an increase in rates cut the credit demand from the private sector? And how would the government credit demand behave? Well, if the inflation is primarily coming from the supply side, the month-on-month increasing trend could have arrested which is not the case, as the impact of currency depreciation, floods and energy price hikes have already been incorporated. Though there will be some impact in the coming month due to recent round of increase, the growing monthly price increases in recent months — especially in food — is counterintuitive.
Is the demand still growing to drive the prices? That is perhaps not the case if we look at the eroding purchasing power, and the falling production trends. However, the production has also reduced due to supply-side restrictions. And in some areas perhaps demand is still higher at constraint supply.
But would that demand be curtailed through a rise in interest rates? Let’s give this thought pause here. There is something else at play.
It seems that the inflationary expectations are well entrenched. That is driving the prices up. Producers, wholesalers, and retailers are expecting shortages in the economy. They are expecting the macro indicators to deteriorate further and the currency to depreciate some more. And that is why they are either hoarding the stuff or selling at premium and that is explaining the growing food and headline inflation.
Thus, the cost of hoarding is less than the credit that is available in the market. But most of these hoarders operate in the informal sector and do not rely on the system credit. But somehow their informal credit rates are loosely connected to the formal interest rates. Hence, an increase in rates can partially address this trend of hoarding.
Then the demand factors cannot be fully ignored. The inflationary expectations are also entrenched in consumers. With growing economic uncertainty, consumers and savers alike are feeling that their savings in PKR are eroding in real terms. Many are buying foreign currencies and gold.
But both are getting short in the market. The other thing they can do is to prepone the buying. They perhaps feel more comfortable having goods in hand instead of cash in PKR. Well, this trend can be arrested by increasing interest rates. As if rates are in positive territory, they may be enticed to invest in fixed income instruments to beat inflation.
But many people in Pakistan do not invest in government papers or banks-fixed deposits due to religious reasons. And many others stay away from formal banking due to documentation fear. This is evident from the currency in circulation of over Rs8 trillion or 30 percent of monetary assets.
But that does not mean that taking rates to positive territory would not address the hoarding by producers and preponing buying by consumers. But for that a big hike must happen to give markets and participants a jolt. Inflation has crossed the 35 percent mark in March and is expected to be in the 30s in the Apr-June quarter. Thus, a meager 1-2 percent increase won’t cut the deal but a healthy 5-6 percent increase can do some damage. Hold this thought.
The elephant in the room is government itself and that is gobbling up most of the fresh credit by far. The private sector is nowhere close to it, to say the least. And at existing high rates amid supply-side constraints, the private sector is shedding credit from its books by selling assets like real estate.
Any big hike would certainly make many businesses default on loans. And the government’s real issue is debt servicing with over 80 percent of government domestic debt linked to short-term rates (be it T-Bills or PIBs floaters). The government is already paying more in debt servicing than its net fiscal revenue.
Any increase in rates to exacerbate the problem would increase the chances of domestic debt restructuring, which could be a nightmare. Thus, higher increase repercussions could surpass benefits. But it’s necessary to send a strong signal across. That is why the doctor’s prescription is to go with the market’s expectation of 1-2 percent increase. And that is perhaps what satisfies the IMF as well.
Copyright Business Recorder, 2023