A 50 basis points cut in key policy rate based on inflationary projections showing a declining trajectory is not expected to lower the lending rates unless government reduces its reliance on the banking system. Further, the inflationary expectations are deeply entrenched in our economy and the expected increase in electricity and gas tariffs is yet to work through the Consumer Price Index (CPI).
According to a survey of 1086 companies, firms have been increasing prices every three months on the basis of increase in raw material prices and depreciation of PKR against major global currencies. Various inflation models of SBP indicate that the expected CPI to drop from 13.9 - at the end of June 2010 - to 11 to 12 percent range in FY12. This provides a 190bps headroom for real interest rate reduction. SBP, however, took a cautious approach and opted for a mere 50bps cut as it awaits the impact of energy price hike and supply side shortages on inflation.
Both Karachi Interbank Offer Rate (Kibor) of different tenors and Weighted Average Lending Rate (WALR) have thus far broadly followed changes in Policy Rate. Against 150bps increase in SBP Policy Rate during FY11, six-month Kibor and WALR have increased by 143bps and 103bps, respectively. While the movement in Kibor is a reflection of monetary policy stance and prevailing liquidity conditions, changes in WALR are also greatly influenced by credit demand of the private sector. Muted incremental credit demand of the private sector during FY11 partially explains a lower increase in WALR. Unlike lending ratio, the Weighted Average Deposit Rate (WADR) did not register any significant change in the corresponding period as it increased from 6.8 to 7.2 percent in one year.
This indicates that the assumption that an increase in policy rate will induce banks to offer higher return to attract deposits and also reduce the incidence of currency in circulation did not work. An absence of competition in the banking system and a lack of financial deepening and the positioning of 30.6 percent of deposits at zero rate of return also explain the overall low WADR.
Trimming the discount rate by 50bps may lead to a Rs 4 billion net saving to the government on servicing of rupee debt. Had SBP chosen to keep ''Real'' interest rate at minus 100bps the government would have reduced the stock of its debt by one percent a year. This would force banks investing in Treasury Bills to pay a price unless they start redirecting their funds to higher risk borrowers. In case, banks remain ''shy'' due to rising incidence of NPLs and continue to lend to government heavily, it will then be the depositors who would be financing government debt indirectly. Not a bad alternative to people who do not pay taxes. The strategy employed by banks has helped them enjoy the option to deposit their surplus cash at 11 percent with SBP, although they offer their depositors much lower rate of return.
Lowering rate does not cause any dent on government''s almost omnipresence in private credit markets. The crowding out would continue to persist unless government raises revenue by taxing all kinds of income irrespective of sources and cuts expenditure in a demonstrable way. Last year, subsidies shot up from a budgeted figure of Rs 127 billion to a whopping Rs 380 billion. In addition, the stock of credit to Public Sector Enterprises (PSEs) increased by Rs 36.3 billion in FY11, which was less than half of the amount availed in the entire FY10 (Rs 85 billion). The stock of credit to PSEs stood at Rs 387.6 billion and their ever-deteriorating financial health remains a cause of serious concern and profound frustration.
Reducing rates implies an accommodative monetary stance in response to the original sin, ie, currency note printing. The government did manage to reduce its stock of borrowing from the central bank by Rs 135 billion from mutually agreed limit of Rs 1290 billion on cash basis, to Rs 1155 billion as on June 30, 2010. However, in order to meet this target, the government increased its reliance on scheduled banks and this trend was found in the ascendant in the second half of the fiscal year. Although, the retirement of borrowing from SBP bodes well for inflation expectations, continued dependence and increasing reliance on scheduled banks causes a serious setback to private sector''s lending prospects. The stock of government borrowing from SBP represents the monetary overhang which is working its way through the economic system. Unless SBP and Ministry of Finance enforce an institutional arrangement to retire five to 10 percent of the stock of Rs 1290 billion every year the long-term inflationary expectations will not be addressed in an effective and meaningful manner.
The central bank also needs to relax Prudential Regulations for the SMEs and simultaneously curb the availability of export finance at concessional rates to the ''big boys'' (top 100 are gobbling up 73 percent of export finance). They can fend for themselves and do not need this facility at all. In addition, SBP and Government need to formally introduce deposit insurance and increase the CDNS rate to reduce the stock of currency in circulation which is now at a very high level of Rs 1.5 trillion, ie, 29 percent of money supply (M2).
Last year, exports were mainly stimulated by a highly significant rise in cotton prices. Increase in inflow of home remittances was due to switch from informal to formal channels. The country''s economy witnessed these two positives on its external front despite a stable exchange rate as there had been only a 0.5 percent depreciation of PKR against US dollar in the entire year. This strongly indicates that external position of Pakistan is inelastic to either the exchange parity or interest rate differentials. However, in the event of any sudden fall in the rupee value, the situation could lead to capital flight and dollarisation. Therefore, managing bulky oil payments and debt repayments by keeping volatility in check in forex market is essential. This crucially requires maintaining the official parity and open market rate within a close band of 25 to 50 paisa to a dollar.