SBP has increased the policy rate by 1 percent to 21 percent. The increase is slightly less than the market’s expectations.As per different surveys; most market participants were expecting an increase of 200 bps. Sources reveal that external membersof the monetary policy committee were of the view to increase 200 bps while SBP emphasized 100 bps, as SBP’s forecast model had churned out the recommendation of 100 bps as well. Hence, 100 bps it is.
If the objective of the rate hike is to un-anchor the inflation expectations, a bigger increase of 500 bps or so could have done some magic. However, that would have many adverse implications. And at this point with rates already over 20 percent, 100 bps or 200 bps really doesn’t matter much. The catch is that fiscal discipline and political clarityis warranted to usher economic certainty and to manage inflation expectations.
Inflations expectations are becoming entrenched for two primary reasons. One is shortage of products in the market – due to administrative control on imports. And the second is expectations of further currency depreciation. Both are linked to the revival of the IMF program and meeting of financing gap to keep the external account flowing without default on sovereign obligations. And that is linked to the political crisis the country is facing. The day there is some political consensus and a direction towards the future, the external financing gap shall be bridged, and the IMF program is going to return to track. That may bring stability and possible appreciation in the Pak Rupee. And having SBP reserves at a certain level would allow imports to normalize to address these shortages.
Without these two, a massive increase in interest rates could only lure hoarders to keep the money in fixed income instruments and the goods supply in market could improve; but the issue of shortages would remain unresolved.
The demand side pressures, otherwise, are largely unabated. The economy has slowed down to dangerous levels in March 2023. Petrol sales are down by 28 percent in March 2023, and 16 percent in 9MFY23, and diesel sales are down by 43 percent in March 2023, and 24 percent in 9MFY23. Cement domestic sales are down by 30 percent in March 2023, and 18 percent in 9MFY23. The situation is similar or worse in many other industries – autos have taken the worst hit.
With this kind of demand profile, there is little justification for any further increase in rates to manage demand. And on the supply side factors -shortages and currency - as mentioned above, developments on the political scene are much more important to stabilize. The key is to have a balance in fiscal and monetary policy, as one alone cannot do much, and without fiscal side being in control, monetary policy would have limited efficacy.
Moreover, with rise in interest rates, the fiscal deficit grows further, as the government debt servicing cost increases; majority of government long term domestic debt is priced on floating rates and has direct bearing with increase in rates. And the growing debt servicing cost is making the fiscal side unsustainable, and there are talks of debt restructuring where effective repayment of the government debt servicing must be curtailed either through haircut or lower NPV of debt – effectively lower interest rates. Hence, the interest rate increase, in case of government debt restructuring would be effective for curtailing private credit which is already going down.
Hence, the decision makes sense. And it correctly depicts a sorry state of affairs. And the other reason for the lower increase is that the IMF program is in limbo anyway due to the financing gap. And if that is arranged and still the IMF wants an increase that can be done by way of an emergency meeting anyway. Either way, SBP is continuously behind the curve. Let the legacy continue.
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