ON November 17, the State Bank of Pakistan (SBP) announced a hefty 150 basis points cut in its discount rate — the largest slice so far in a single day other than those announced during the traumatic days following May 29, 1999.
In view of the noises being made by APTMA, on November 29, the ‘discount rate’ was followed by a cut of 100 basis points in the state-subsidized export re-finance loan rate in the drive for lowering the cost of bank credit to exporters. After all the concessions made to them during 2002, majority of the exporters may still fail to improve their competitive position. Their archaic production facilities and high leverage prevent them from doing so.
The argument advanced for cuts in the discount rate is the “dropping” level of inflation. In reality, though, the move fulfils the wishes of Mr. Shaukat Aziz, former federal finance minister, who had promised to the industrialists a 200 basis point cut in bank lending rates, nearly a month ago. The argument about the “drop” in inflation is not credible because, according to the 2001-02 SBP Annual Report, based on 1990-01 price levels, by June 2001, the CPI stood at 233.24 representing 133.24 per cent inflation over the 10-year period.
The average annual rate of increase thus was 13.32 per cent. Effective July 2001, the basket of goods and services for calculating CPI was changed. Not surprisingly,therefore, based on July 2001 price levels, by June 2002, CPI rose by only 4.90 per cent. Although no one believes that this low figure represents the true rate of rise in inflation, it helped project low inflation to support the case for lower profit rates on government debt.
In spite of the rhetoric about aligning cuts in discount rate with drops in inflation, since October 2001, a credible drop in inflation did not proceed these cuts. The cuts only helped the government in rapidly reducing the cost of domestic public debt to control the runaway fiscal deficit that is rising with falling economic growth and productivity, and as a welcome by-product thereof increased the pressure on banks for extending cheaper credit to the industry.
It is obvious that Mr. Shaukat Aziz succumbed too easily to the lobbying of the industrialists, and the way he influenced the monetary and exchange rate policies of SBP to serve this lobby, is astonishing. The sufferers have been the common savers because inflation has consistently been rising, and will remain so because industrialists will not return the favour by cutting prices.
Acceding to demands for concessions that allow sustaining inefficiency rather than containing it through improved management, reflects imprudence. Mr. Shaukat Aziz obviously cares more for popularity rather than forcing the industrialists to change their archaic production bases and managerial styles, and effectively check the lack of professionalism in dealings that drive away even existing buyers, let alone make inroads into new markets.
He has not asked himself whether the industry deserves support through low bank lending rates — an incentive to borrow more — or should the industry shed its high leverage to minimize the cost of borrowing? Interest payments are already absorbing the lion’s share of profits in companies, which points to the need for shedding leverage rather than living with it. What the industry needs more urgently is the rationalization of fuel and energy prices not cutting interest rates but the drive for privatizing the PSO, the OGDC, the KESC, etc in high gear, such steps can make these entities unattractive for potential buyers, which the finance minister obviously doesn’t want.
Inspired cuts in discount rate encourage industrialists to build unbearable pressure on banks. The impression that Pakistani banks are earning too large a spread over the cost of their deposits is a gross mis-judgment. It is proved by the fact that in spite of a 500 basis point cut in the SBP discount rate since 2000 they were able to lower their average lending rate only by 33 basis points. Admittedly, they are inefficient but under their present circumstances, they are incapable of cutting their costs or squeezing their margins quickly enough to lower the lending rates.
While their low profitability has been pointed out time and again by the World Bank what compounds their predicament now is the pressure for raising their equities, bulk of which they will have to manage out of profit because, with their recent track record of having issued right shares too often for the liking of investors, equity issues are unlikely to be subscribed fully. The scenario will not permit them to squeeze their margins to pay positive real rates of return on deposits.
Pressure for cutting interest rates has been exacerbated by falling economic growth, rising fiscal deficit as a result thereof, and a flood of savings being received from abroad (courtesy 9/11) a large part of which represents return of funds earlier stashed away by industrialists. In a depressed economy, rapid increase in deposits due to exogenous factors, and near 50 per cent drop in fresh credit expansion is making banks uncomfortably liquid. They are, therefore, investing heavily in government debt forcing the government to cut rates payable on its papers. This cannot be done in isolation; it must be accompanied by lower cost of borrowing from SBP discount window. Hence the need for cuts in the discount rate, which is what the SBP has been doing since October 2001 benefiting the government and the industry — both inefficient users of public savings — at the expense of savers.
The single most important lesson to be learnt from the on-going world recession is that domestic demand rather than exports should be the mainstay of any economy. This lesson has been learnt only recently by Pakistani bankers who are now talking about “putting money in the pockets of the people.” Surely, this end can’t be achieved by giving them a bad deal on their savings. Since 1993, saving account holders, who provide banks nearly 50 per cent of their deposits, were paid a negative real rate of return because inflation remained consistently higher than the average rates of profit paid on these deposits. It is therefore no surprise that rising poverty has dampened domestic demand.
Lowering interest rates in isolation has been counter-productive in the long run as proved by low interest rates since the mid-1990s, ostensibly to spur demand and economic activity, resulted in acquisition of excessive debt by businesses, and creation of over-capacity there from. Similarly, households too acquired credit, which was far in excess of their capacity to save and repay. The credit boom, and the demand created consequently, initially led to meteoric rises in prices and deluded industry into over-investing in capacity building. However, the unsustainable burden of debt-servicing eventually forced businesses to crash.
Lowering interest rates without a credible basis therefor, transfers advantage unfairly to the borrowers. It has allowed both government and the industry — both net borrowers — to cut their costs at the expense of the savers without the savers being compensated through lower inflation and increase in their real purchasing power afforded by lower prices. That this is indeed happening is proved by the amazing rise in profitability of large corporations, particularly in the automobile and petroleum sectors. Big banks with large government bond holdings will benefit from cuts in the discount rate as market value of their existing holdings rise with each hefty discount rate cut.
Central banks can overlook the sensitive nature of interest rate management only at the expense of the grave long-term implications it has for consumption, saving and investment sentiment. It is a pity that the debt that we acquired to meet the shortfall between domestic saving and investment needs, has not served to open our eyes. Nor do we appreciate the fact that lower profit rates may push the already inadequate savings out of banks into insecure or speculative investments. The less well-informed (forming the majority of savers) may opt for placing their savings with unscrupulous moneylenders because the corporate bonds market is far too small to cater to their needs and a large secondary market has yet to emerge to assure savers of ready liquidity. The more enlightened may opt for investing in stocks, but being largely uninitiated to undertake such investment they may suffer from bad advice. It happened all over the world. US market is its classical example where 50 per cent of the households invested in shares at inflated prices that later dropped by much as 40 per cent, leaving the poor shareholders with net negative equities.
Evidence of similar disasters is not lacking in Pakistan’s history. What makes the prospects of such a disaster more imminent is the stark reality that the present recession is unlikely to subside in near future. With domestic demand petering out and exports as well as foreign direct investment unlikely to rise, given the damage done to Pakistan’s image (perceived support to militants), sustained corporate sector profitability seems unlikely. The inflated share prices could fall, and rapidly. Notwithstanding the skyrocketing of the KSE-100 index, the fact remains that sentiment for investment, which is demonstrated credibly by floating of new companies rather than manipulated stock price indices, is unmistakably subduded. It is therefore worth pondering whether, under such circumstances, diversion of savings from banks to these venues would be advisable. Or is it better that small savings are routed to business and industry through the caretaker system of banking but without being unfair to them because their confidence in the regulators plays the most crucial role in making any economy self-sufficient?
