04 October 2004	Monday	18 Shaban 1425

The latest increase of half a percentage point in the State Bank's refinance rate for October 2004 is a clear indicator of how interest rates will move in the months to come and how they will affect various sectors of the economy.

The central bank, on September 30, announced to raise the refinance rate from 2.5 per cent to 3 per cent because on September 15 it had increased the weighted average yield on six-month treasury bills by 38 basis points to 3 per cent.

The SBP uses the weighted average yield of six-month T-bills of the preceding month to fix the export refinance rate of the next month and it allows banks to charge a maximum spread of 1.5 per cent over the refinance rate.

Thus, exporters will get export loans under the Export Finance Scheme at a maximum mark-up of 4.5 per cent this month. Till May 2004, they were getting export loans at 3 per cent as the refinance rate was at 1.5 per cent.

The central bank has raised the refinance rate in three installments to 3 per cent for October from 1.5 per cent in May reflecting the increase in weighted average yield on six-month T-bills during this period.

The State Bank tagged export refinance rate to the average yield on six-month T-bills in 2001 on the insistence of the IMF to end interest rate subsidy on exports. When the central bank last revisited its discount rate in November 2002 and cut it 150 basis points to 7.5 per cent it slashed the average yield on six-month bills by almost a similar margin.

The central bank also reduced the export refinance rate by 100bps to 5.5 per cent for December 2002, which allowed eligible exporters to obtain export loans from the banks at 7 per cent instead of 8 per cent.

Since then export refinance rate kept falling and it finally sank to 1.5 per cent in August 2003 as the SBP went on slashing T-bills yields during this period to signal further loosening of monetary policy.

In ten out of twelve months of the last fiscal year (August 2003 to May 2004) export refinance rate remained pegged at 1.5 per cent and banks continued to offer export loans at a maximum mark-up of 3 per cent.

Banks with excess liquidity made even cheaper export financing at times to their prime borrowers and top businesses sometimes received export loans at 2-2.5 per cent. This contributed a great deal to growth in exports that rose 10 per cent to $12.273 billion in the last fiscal year from $11.16 billion a year earlier.

Export target: The export target for the current fiscal year is $13.7 billion and in the first two months of the year exports have totalled $2.359 billion. If this high pace of exports keeps up, full fiscal year export earnings should reach $15.6 billion. So, there is no reason to worry about growth in total exports even if average exports falter occasionally.

Import target: But the real problem is that not only exports seem set to surpass the target of $13.7 billion, imports are also bound to burst through the target of $16.7 billion because of soaring oil prices.

Imports totalled $2.848 billion in July-August and if they keep this pace throughout the year the total import bill would be slightly higher than $17 billion. But as oil prices for deliveries in September onwards have been much higher than in July-August, and as they show no sign of receding in near future, the import bill for September onwards would be on the rise.

The government has not revised export, import targets but a general feeling is that exports may rise to $14.5-$15 billion and imports to $18.5-$19 billion. Thus, the trade deficit should reach $4 billion, against the target of $3 billion. Some analysts say it may even touch $4.2 billion, up from $3.2 billion in the last fiscal year.

High growth: So there is an urgent need to achieve as much growth in exports this year as possible. One should also keep in mind that the end of textile quota regime from January 2005 vay not benefit Pakistan in the first six months, though in the long run it would help the country increase textile exports.

Observers say, and textile tycoons do agree, that the first six months of quota-free regime (January-June 2005) would be consumed in making necessary adjustments and in exploring the ways for grabbing a larger market share. This makes the task of achieving a very high growth in exports all the more difficult.

How it hurts: When seen in this backdrop, a continual increase in the markup on export financing seems quite disturbing. What makes it look more disturbing is that there seems to be many more increases in export refinance rate in store as SBP needs to tighten interest rates further to check inflation.

Consumer inflation shot up by 9.29 per cent in July-August 2004 over July-August 2003 and is bound to shoot up further after the government defreezes domestic oil prices that have remained frozen since May this year. The government may defreeze these prices immediately after Eid, in the middle of November 2004.

Falling rupee: In the first quarter of this fiscal year, the rupee lost 1.9 per cent of its value coming down to 59.24 a US dollar on September 30 from 58.13 on June 30.

This should offset the impact of rising mark-up on export financing to some extent. But the central bank may not allow the local currency to fall sharply just to benefit exporters.

It may, however, also not go out of its way to keep the rupee stable. The reason is that keeping the rupee stable amidst expanding trade deficit would require large net selling of dollars in the inter-bank market.

This would reduce the foreign exchange reserves, which SBP would not allow in view of a rapid increase in the reserves of other countries notably India. Besides, this would negate SBP's policy of making exchange rates market-based.

Tricky situation: So, this is a tricky situation. Inflation is going to rise as the economy is set to grow faster this year than in the last year and as the government is going to de-freeze domestic oil price. The SBP will surely keep raising T-bills rates to contain inflation. That is bound to make export financing costlier.

Growing external sector problem, primarily due to high oil prices, is going to weaken the rupee further. That will partly offset the impact of higher export finance rates. But again, de-freezing of oil prices and consequent increase in inflation is going to add to the cost of production. And, whereas the fall in the rupee value would benefit exporters to some extent, that would be offset by the resultant increase in the cost of imported inputs of export-based industries.

Ironically, exporters also cannot borrow aggressively in foreign currency at a time when the dollar is appreciating because that effectively means a higher cost of borrowing. They have to depend on local currency borrowing. And finally, the doing away with the textile quotas in January 2005 is not going to impact favourably on Pakistan's exports in the very short term i.e. during this fiscal year.

What to do: So, what can be done? One way for providing immediate relief to exporters could be that the banks reduce their spread from 1.5 per cent to 1 per cent or 0.5 per cent over export refinance rate.

This would help SBP continue to tighten interest rates to contain inflation without bothering about its impact on concessional export loans. If this happens, the SBP would also find it easier to depreciate the rupee in a measured and gradual way.

Meanwhile, stronger efforts should be made to attract as much remittances from overseas Pakistanis as possible. A higher inflow of remittances would help reduce the pressure on the external sector thereby compensating for the limitations that may face the country in boosting exports by the desired pace. In the first two months of this fiscal year, workers' remittances or money sent back home by overseas Pakistanis, rose by 16 per cent to $669 million.