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Intricacies of the policy rate hike

This is not the time for keeping interest rates stable.

The State Bank of Pakistan (SBP) has given its verdict against the government’s desire for — and most analysts’ predictions about — no interest rate hike. The SBP has raised its policy rate by 25 basis points to 10.25pc for February and March.

At a meeting of the Monetary and Fiscal Policy Coordination Board held two days before the announcement of the 25bps rate hike, central bankers built up a case to increase the rate by a bigger margin. But the government did not agree, fearing an unmanageable increase in the cost of its domestic borrowing. It argued that in the light of the ongoing fiscal consolidation, there was no need for a substantial rate hike. So the SBP kept it symbolic.

Analysts view the unwillingness to accept ‘harsh’ conditions of an IMF lending programme as the government’s unwillingness to do what is politically taxing

But while announcing this symbolic decision, the Monetary Policy Committee of the central bank did not mince words in reminding the government of the challenges facing the economy and the fact that core inflation remains quite high. Almost all analysts of leading brokerage houses were expecting no change in the policy rate.

So the question arises whether the latest rate hike is uncalled for. Future movements in fiscal and external accounts will show if the government is right in demanding no rate hike.

However, it is good to see that the coordination board met before the monetary policy announcement instead of the fiscal authorities dictating the SBP.

Both measures of inflation, headline and core, are rising this year, the fiscal deficit remains high despite cuts in development expenses and the current account deficit is showing a marginal improvement even after billions of dollars of borrowing from friendly countries.

Against this backdrop, the central bank’s decision to let a tight monetary policy continue makes lots of sense. And even a symbolic rate hike should hopefully keep the direction of monetary policy clear for banks and financial markets.

Now the challenge for the government is to focus more on revenue generation, keep its non-development expenses in check, address structural issues in the external account and avoid things that can add to existing political uncertainty.

Failure in any of these areas can frustrate plans to avoid a steeper fall in the economic growth rate and efforts to rein in inflation.

Ongoing discussions with the International Monetary Fund (IMF) need to proceed in the right direction. Immediate balance-of-payments support from the Fund must be secured sooner rather than later, top bankers and stockbrokers say.

Their point is that this can help send a signal to the international investors’ community that the economy is not becoming too reliant and thus persuadable in the geo-strategic interests of a select group of friendly countries.

Besides, too much talk about the government’s unwillingness to accept ‘harsh’ conditions to be attached with an IMF lending programme can also be seen as its unwillingness to do what is required but is politically taxing, they say.

The latest hike in the policy rate will naturally be followed by higher interest on treasury bills and bonds. The government will find it difficult to continue to borrow excessively from the banking system to finance its fiscal deficit. So far in this fiscal year (up to Jan 18), the government has relied heavily on borrowing from the central bank (or currency note printing in plainer words) to retire the accumulated debt of commercial banks.

Between July 1, 2018 and Jan 18, the federal government’s borrowing from the SBP quadrupled to Rs3.98 trillion from Rs1.05tr last year. Credit to the private sector will also become costlier as the interest rate tightening by the central bank will be followed by an increase in banks’ fresh lending rates.

The government will now find it difficult to continue borrowing excessively from the banking system to finance its fiscal deficit

Banks’ net fresh lending to the private sector in the current fiscal year more than doubled to Rs506bn from Rs216bn in the year-ago period.

Will higher interest rates on corporate and commercial lending impact demand for credit at a time when economic growth is slowing down? “Consumer financing is sure to suffer from higher interest rates if, instead of taking a futuristic view of this sector’s current plight and growth potential, banks make consumer finance costlier,” says a senior executive of the state-run National Bank of Pakistan.

One aspect of the need for a tight monetary policy, which is not widely discussed, is the ongoing build-up in reserve money that has a more direct impact on inflation than overall money supply or broad money.

Due to rapid foreign exchange inflows from Saudi Arabia and the United Arab Emirates, the rupee counterpart of those foreign exchange funds are becoming part of our reserve money and pushing up its growth. Whereas such inflows provide a much-needed cushion to the SBP’s foreign exchange reserves, their above-mentioned impact on reserve money growth through an increase in net foreign assets or NFA — and by extension on inflation — cannot be ignored, explained a central banker.

This is one of the several reasons why the SBP wanted to increase its policy rate by a wider margin.

Besides, according to them, a substantial rate hike in one go has traditionally proved more effective in tackling inflation than piecemeal increases.

However, central bankers insist that in recent years, the transmission of monetary policy signals has improved and even a quarter percentage-point hike in the rate provides the right signal to financial markets. That is, the central bank is serious in fighting inflation and stabilising the rupee.

But the fact that the latest hike is the fourth one in this fiscal year is considered too rapid by many in the Ministry of Finance. But then they have to contend with it on the ground that both the devaluation (about 13.8pc in seven months of 2018-19) and the 375bps increase in the policy rate have come in the backdrop of large fiscal- and external-sector imbalances ahead of an IMF bailout package.

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