Policy rate cut

The Monetary Policy Committee (MPC) met for the third time in less than one month on 16 April 2020 and reduced the rate to 9 percent - from 13.25 percent effective 20 July to 16 March, 12 .5 percent from 17 March to 23 March and 11 percent effective 24 March to 15 April 2020. The question is why did the MPC hesitate to reduce the rate to 9 percent on 24 March given that the same day, in acknowledgement of the massive negative impact of the Coronavirus on the economy in general and the poor and vulnerable in particular, Prime Minister Imran Khan announced a relief package of 1.2 trillion rupees?

The interesting thing to note is that while the IMF staff report on request for purchase of Rapid Financing Instrument supports the cut in policy rate to 11 percent to "prevent disorderly market conditions" that allowed the exchange rate to act as a shock absorber accommodating an 8 percent depreciation (27 February to 9 April 2020) of the exchange rate versus the dollar" yet it warned "with inflation still in the double digits...the need to remain vigilant of potential inflationary pressure arising from the rupee depreciation and supply side pressures." The decline to 9 percent therefore may not be supported by the IMF and may reflect political as opposed to purely economic compulsions.

MPC has been much criticised for raising the discount rate to 13.25 percent rate, though the raise to 12.25 percent was an IMF prior condition - a decision that critics argue was based on two flawed decisions. First the discount rate was linked to headline as opposed to core inflation subsequent to Dr Reza Baqir's appointment as governor of the State Bank of Pakistan (SBP) on 6 May 2019. Previous governors and independent economists have since been arguing that this linkage is inappropriate as major headline inflation components, particularly petroleum and products and energy prices, are not linked to the discount rate - a stance fully supported by an SBP research paper on its website; that the inexplicable linkage between headline inflation and discount rate has not been abandoned is evident from the 16 April MPC statement: "both the March CPI outturn and more recent weekly SPI releases in April also show a marked reduction in inflation momentum" and "while there are some upside risks to headline inflation in case of temporary supply disruptions for food price shocks there are unlikely to generate strong second round effects due to the weakness of the economy." SPI declined from 16.38 percent on 13/2/2020 as per the Pakistan Bureau of Statistics to 7.69 percent on 16/4/2020 with a price decline of 8 items, price increase of 16 items with 27 items registering no price change. The lockdown would have made SPI calculation of all markets a challenge especially with respect to the 27 items whose prices did not register a change.

The Prime Minister publicly acknowledging a danger of illegal dollar outflows however one would hope that he was briefed about the legal outflow of dollars due to the high discount rate - hot money - which has since left the country due to the onset of the pandemic. The SBP quarterly report's claim that 'core inflation softened due to macroeconomic stabilization measures (including the increase in interest rate, fiscal consolidation and realignment of the exchange rate with fundamentals) have proved largely effective' can be easily challenged given the stifling of economic activity and rising unemployment levels that predate the onset of the pandemic. Stabilization is not only about reducing the current account imbalance as persistently claimed by the SBP but about growth and employment opportunities.

Secondly, the SBP argues that "Real Effective Exchange Rate must not be confused with the concept of currency overvaluation (undervaluation)....for assessment of a country's misalignment a more sophisticated analysis is required accounting for factors such as demographics, external and fiscal sustainability, and macro fundamentals over the medium term?" Ironically, the recent SBP quarterly report states that "though PKR appreciated in both quarters of FY20, the Nominal Effective Exchange Rate (NEER) depreciated in the second quarter (against appreciation in Q1) as the currencies of other major trading partners appreciated against the dollar. However, the higher RPI (relative price index), due to higher domestic inflation, resulted in REER appreciation in both quarters of FY20." True but the rupee remains undervalued, a fact that the report did not conveniently highlight.

The 16 April MPC argues that the "rate cut would complement other measures taken by the SBP to support the economy, including concessional financing to companies that do not lay off workers, one year extension in principle payments, doubling of the period for rescheduling loans from 90 to 180 days and concessional financing for hospitals and medical teams." The second quarterly SBP report maintains that "firms heavily utilized Libor based foreign currency loans and relied less on expensive rupee denominated loans as well as concessional facility of SBP." And further acknowledged that "credit to private sector continued its downward trajectory with yields falling more steeply at the longer end; this was due to two reasons: (i) on the demand side the market players continued to place bids at lower rates for longer duration bonds in anticipation of monetary policy easing; and (ii) on the supply side the government proactively aligned the long term rates to reduce its cost of borrowing."

So given the fact that the recent MPC statement restates its adherence to these two flawed policy decisions why did the SBP reduce the rate on 16 April? The short answer is that the rate reduction would reduce the allocation for debt servicing and repayment as and when due thereby creating fiscal space enabling it to inject more into Coronavirus relief activities. The rupee value has also declined in recent days reportedly due to the decline in the discount rate however with the main borrower being the government even before the onset of the coronavirus external debt would be brought down further generating more fiscal space. In short the SBP measures support the government's efforts which have prompted the rumour that the MPC was given an ultimatum: reduce the rate or else face possible retrenchment.

The question is if the 16 April rate decline was appropriate? It is unlikely to jump-start the private sector in spite of recent policy amendments given that the private sector credit was declining pre-Coronavirus due to the contractionary fiscal and monetary policies agreed with the IMF. True that the Extended Fund Facility (EFF) programme is in abeyance but the IMF has been persistently called for "regulatory measures and expanded refinancing schemes to contain the ensuring economic impact of the Coronavirus to be targeted and temporary." Meanwhile the clamour for another rate reduction is growing louder. To conclude there is an urgent need to revisit some of the flawed MPC assumptions particularly with respect to linking the rate to headline as opposed to core inflation and to ensure that the rupee is no longer undervalued.