12 July 2004	Monday	23 Jamadi-ul-Awwal 1425

The State Bank of Pakistan (SBP) continued with the current easy money policy to spur economic growth by providing cheaper credit to the private sector and at the same time to police inflation.

The borrowers-friendly interest rate environment, combined with skillful use of open market operations, has largely contributed towards reinforcing the ongoing economic growth momentum through accelerated investment particularly in the large-scale industrial sector, while the price situation has not been allowed to be unmanageable during the just concluding fiscal year.

As a result of easy monetary stance, the weighted average lending rate declined from 7.58 per cent in June 2003 to 4.69 per cent in March 2004. The weighted average deposit rate also declined from 1.9 to 1.3 per cent, although there has been some negligible rise only recently.

The spread between the deposit rate and the lending rate remains 3.39 per cent. The export-refinancing rate comes down from 11.1 per cent in July 2001 to 1.5 per cent in March 2004.

The deposit rate is so low that it can no more be termed as an apparatus for mobilizing savings of the people. The monetary expansion during the year amounted to Rs255 billion.

The year also saw an unprecedented rise in private sector credit amounting to Rs245 billion. The benefit of low rate of interest was also filtered down to middle class consumers as the personal loans rose to Rs50 billion. This has also facilitated the management of domestic debt and its repayment.

Notwithstanding many-sided achievements of easy monetary policy, there are some experts and particularly bankers who have started pursuing, rather pressing, the SBP to change the easy stance of the policy with a view to mopping up excessive liquidity and containing the rate of inflation which has started showing upward trends. Meanwhile, the rupee is also no longer holding firm against the dollar.

In a world-wide perspective, the growth is being fuelled by historically low rate of interest. However, trends of rising inflation are now discernible both in USA and Europe, causing concern to their central banks.

The US Federal Reserve has already raised its rate of interest by a quarter of a point to 1.25 per cent for the first time in four years, in order to keep the rate of inflation at bay.

This ends an easy cycle that began in 2001 and took their key rate to 1 per cent, its lowest level since 1958. In Europe as well, inflation is being termed as a consequence of excessive monetary expansion, caused by both the fiscal and monetary policies, being so lax.

The high oil prices have also stimulated cost-push inflation. Although necessary vigilant is being kept on the ongoing inflationary pressure, the European Central Bank has not yet taken any measures to tighten the monetary policy in order to tame inflation.

The difference of perception between the SBP and the commercial banks over the interest rate issue can be judged from the fact that while the SBP does seem in a mood to reverse the existing interest rate, the commercial banks are interested to earn more from their surplus liquidity.

This could be evident from the fact that on 23rd June 2004, the central bank rejected all bids because yields between 2.68 and 3.98 per cent quoted by banks, which were much higher than 2.23 per cent in the last auction.

In another Open Market Operation (OMO) also held on 28th June, 2004, the bids offered by banks were in the range of 2.6 and 3.2 percent per annum for two weeks and four weeks term. The same, being too high, was also rejected by the SBP.

As a result of lower than expected sale of government papers by the State Bank, the money market continued to be flushed with excessive liquidity which is estimated at Rs70 billion presently and will go upto Rs150 billion by the end of July 2004.

This much liquidity will exert pressure on rupee and weaken it viz-a-viz dollar. Money supply between July 1 2003 and June 12 2004 has already risen to above 17 against the target of 11.06 per cent.

The prevalence of record low rate of interest for almost three years has substantially curtailed the cost of bank funding. This spurred the demand for credit by the private sector.

The last FY (July to March 2004), witnessed an upturn in the industrial sector, whose share in the overall bank credit of Rs244 billion for the private sector, comes to Rs126 billion, which has also reflected in the record growth of large-scale manufacturing sector of 17.5 per cent.

Similarly, the disbursement of credit to other sub-sectors including housing, has been quite impressive. Despite phenomenal growth in the banks borrowing by the private sector, the banks continue to face the problem of excessive liquidity.

This points to the fact that the rise in investment has not been in commensurate with the availability of funds and that investment in Pakistan is not interest-elastic and is determined by a multitude of other factors.

During the last four years, investment equivalent to $ 4 billion has been made in the textile sector, but its redeeming feature has been that over 60 per cent investment has been the result of self-financing by the textile entrepreneurs themselves.

It is not only the interest rate alone, but the terms and conditions of banks, especially in project-financing which play a very decisive role. The banks, after the recent banking reforms and new prudential regulations are very cautious and careful to ensure that loans only be given to bona fide and genuine parties.

Second, the interest-component in the aggregate cost of production, is also taken into consideration. Likewise, the pace and pattern of investment is also determined by the taxation and labour policies, the state of infrastructure, consistency in government policies, good governance and law and order situation. Meanwhile, prior to the new package of prudential regulations of SMEs, the rate of interest, especially of SME bank, was over 10 per cent. The demand for investment could also be low, because of low marginal efficiency of capital.

The element of protection to industries as a whole has been eroding, following the low rate of tariff on most of the imported finished goods, in the wake of induction of the WTO regime.

The automobile industry could be an exception, which registered phenomenal growth mainly due to growing demand emanating from low-rate financing and continued tariff protection. The problem is further aggravated because of ongoing smuggling and government's inability to check it.

Therefore, the profit dimension is not conducive for accelerated investment. Meanwhile, the return on savings, both in national savings schemes as well as bank deposits has emerged to be negative, taking into consideration the impact of inflation. This phenomenon has compelled the people to have liquidity preference or invest in such unproductive sectors like real estate or stock exchange.

It is due to these reasons that although the total investment has risen from 16 per cent of GDP in 2002-03, to 18.5 per cent in 2003-04, investment in the private sector has only moved from 11.2 to 11.7 per cent.

Whatever the industrial growth has been witnessed, it is primarily the result either of self-financing, specially in the textile sector or of effective utilization of the installed capacity and the quantum of fresh investment is not very significant.

All available indications reveal that the inflationary pressure has started building up and is over 4 per cent. However, the SBP makes a distinction between core inflation and headline inflation.

Inflation, stemming from petrol and food prices does not fall within the definition of core inflation, but it does form an important ingredient of headline inflation.

During this period, the country has witnessed an upsurge in monetary expansion and accelerated money supply. The developing economies, have a built-in potential for inflation, as there is always a time-lag between the expenditure and supply of goods and commodities. Apart from non-development expenditure, the development expenditure also initially adds to the inflationary pressure.

The annual development plan (ADP) envisaged an expenditure of Rs160 billion last year, which did have an impact on the money supply, because of its growing expenditure on infrastructure, roads, bridges, canals, etc. At the same time, the government's borrowing between July-May 2004 from the banking sector moved as high as Rs64.8 billion against the target of Rs15 billion fixed for the whole fiscal year.

Similarly, the government policy of encouraging consumerism, by providing cheap credit for construction and for the purchase of vehicles, have had share in the money supply, which has risen by 16.8 per cent or Rs83.3 billion during the nine months of 2003-04.

As a result of excessive liquidity in the market, coupled with inflationary pressure, the rupee has started manifesting signs of weakness against dollar. During the month of June, Pak rupee has lost 0.8 per cent against dollar coming down from Rs57.69 to a dollar at the end of May to Rs58.16 per dollar on June 28, 2004.

In conclusion, it must be emphasized that the easy monetary policy, which is being operated for the last three years, has indeed been instrumental in the promotion of investment and export, due to massive expansion of private sector credit. It has also contributed in making the foreign exchange being liberalized and stabilized.

The land-mark of monetary policy has indeed been the stability in price-level. However, now as a consequence of growing monetary expansion and increased money supply, the emerging inflationary trends are visible, which combined with the sudden rise in food and petrol prices, could be threatening to the social stability.

This could also have a negative impact on the government's poverty alleviation programme. The excess liquidity could cause pressure on rupee, leading to further depreciation of its value against dollar.

The SBP must take cognizance of the new emerging trends and make necessary modifications in its monetary policy statement, to be announced on 20th July 2004. The changes would of course be of mild nature, but be adequate to make the policy slightly tight to address the problems of excess liquidity, pressure on rupee and rising inflation, so that the accomplishment of avowed objective of higher growth with tame inflation remains unaffected.