The battle for interest

If nothing else, we are a trail blazing nation. Perhaps for the first time in our history, at least if my memory serves me correctly, there is a likelihood that the legal profession, lawyers and judges, and not economists and nor the Central Bank, may end up deciding interest rates.

Kudos to the petitioner for possibly providing this exciting opportunity which the media circus will surely latch on to; and at the same time, best of luck to him in his quest to explain to the legal fraternity a subject which in entirety entails the study of a fictional world where all else can be held constant, and proof of concept is unnecessary beyond models based on fantastic assumptions, including the rational superman.

So here is hoping that the superior courts take up the challenge; but exactly what is it all about, is a valid question. In summary, the State Bank of Pakistan increased interest rates to fight inflation, which apparently had exceeded inflation targets; and there are those who doublethink this decision.

But, in layman parlance, what is really going on? What has interest got to do with inflation in the first place?

Well, it is common sense that higher interest rates increase the cost of borrowing. So those of us, who generally over spend on credit cards and/or have leased cars or mortgaged homes, will end up paying more to the banks in interest, and unless our incomes increase proportionately, we will have less money to spend on other stuff, and hence by default will have to cut consumption - resultantly inflation will come down. Why? Well in simple terms, if demand for something goes down, its price will also have to come down.

Notwithstanding that even the famous supply-demand curve in economics is suspect in the real world, the bigger problem is that Pakistan by and large is a cash economy and very few individuals have consumer loans in the first place; or bank accounts for that matter. Additionally, since Pakistan is experiencing cost-push inflation - rising prices because of rising cost of utility and energy, higher taxes, increasing cost of imports due to devaluation and rising food prices - higher interest rates by and large will be ineffective in making an impact; and there is a very real possibility of stagflation.

Albeit some economists hold a view that cost-push inflation is a myth and inflation only has to do with money supply - this argument is too complicated for the current discussion so parked for another write up in the future. But like I said, you can argue anything in a fictional world!

Increased cost of borrowing would also reduce investment; not that the private sector was investing in projects even when the interest rates were much lower- a more serious issue at least in my opinion. Nonetheless, higher interest rates do impact business confidence, making entrepreneurs less willing to take out risky investments. What, however, has happened is that the cost of borrowing for the state has doubled, since it can now no more borrow from the central bank, thanks to our lender of last resort! Resultantly, public consumption has declined significantly; the development budget has been slashed.

Let there be no doubts, reduced investment and reduced consumption lead to lower economic growth and consequently lower employment - if people stop buying stuff, businesses have no incentive to produce, and will therefore cut costs, mostly wages. So predictions of GDP improving soon are rather overly-optimistic.

To continue, as the theory goes, higher mortgage costs also bring down house prices and hence lower inflation; and this sounds logical even. Albeit, house prices had bottomed out even before inflation started rising, courtesy the government's efforts to rein in black money and regularise the real estate sector. So not much luck there either.

Another consequence of higher interest rate, according to the theory, is increase in savings since it now becomes more attractive to save in a deposit account than spend in a restaurant - that too makes sense. But when the middle class is already struggling, and by and large failing, to make ends meet, who has the money to save in the first place. In fact those in the upper middle class, who probably had some savings, are now paying banks more to cover for the increased consumer borrowing obligations. The rich, by the way, never have to worry about consuming- higher interest rates are celebration time for them, they get more money on their savings and get richer.

Finally, let there be no doubt, higher interest rates attract hot money, resulting in appreciation in the exchange rate, consequently lowering inflation. Unfortunately, because of our past indulgence, we had to depreciate our currency very significantly, and hot money will really have to flow a lot for the tide to reverse. Considering we have still not learnt our lesson and carry a huge trade deficit still, despite the recent reduction, the likelihood of any significant appreciation will remain hugely improbable. On the other hand, the risks associated with hot money remain current and real - essentially it is sort of a Ponzi scheme, everything is hunky dory until the inward flows continue.

In a nutshell, whether or not higher interest rates can or have controlled inflation, they surely have made things bad for the government which now struggles to cover its debt obligations, and has limited options going forward, none of which are typically likable. Forcibly bring down interest rate which is sort of a financial repression, what the petitioner wants; print money and risk hyperinflation; or default, the consequences of which will probably be the worst.

There is an argument that the government can balance its budget by increasing taxes; however, easier said than done. As pointed out above, higher interest rates do adversely impact growth and more taxes means more inflation, and this perhaps is a different kind of repression.

So where should us laymen stand in this melee?

Don't! Sit down on your favourite sofa in front of the idiot box, and let the battle for interest begin!

(The writer is a chartered accountant based in Islamabad. Email: [email protected]. The views expressed in this article are personal. The views are not necessarily those of the newspaper)