U-turn in monetary policy

Published Sep 16, 2013 01:04pm

AFTER reducing its key policy rate by 50 basis points to nine per cent in June, the State Bank of Pakistan has raised it to 9.5 per cent for September-October, citing the need ‘to contain inflationary expectations in the economy’.

This rather abrupt reversal of monetary easing has drawn criticism from the business community, with representative bodies like the Karachi Chamber of Commerce and Industry saying the step would slowdown industrial recovery and lead to a buildup of bad loans.

Exporters say it would make competition with India all the more difficult in the presence of stable interest rates there and the recent plunge in the Indian rupee’s value, which has given Indian exporters a big edge over them.

The central bank, which skipped its monetary policy review in August and decided instead to change the schedule of policy announcements, fears that inflation would be in the double-digits again during this fiscal year, after falling to 7.4 per cent last year.

The SBP says that the withdrawal of energy subsidies, as well as prospects of high government borrowing from the central bank and the increase in the general sales tax, together with the removal of certain tax exemptions, may ‘put further pressure on inflation in the coming months’.

The monetary policy statement also points towards the possibility of an increase in global fuel oil prices in the backdrop of ‘escalating political tensions in the Middle East,’ in an obvious reference to a possible military conflict in the wake of the Syria crisis.

At a time when industrial growth has picked up pace at least in part due to declining interest rates, why couldn’t the SBP keep the policy rate unchanged to avoid depressing the sentiments of production recovery? Was the central bank really concerned about the rising inflationary expectations? Or does the rate hike have anything to do with the IMF-Pakistan agreement? These are the things that businesses will continue to speculate.

Interestingly, as the central bank announced a modest monetary tightening, the Pakistan Bureau of Statistics updated the July 2013 data on large-scale manufacturing, which showed a 3.7 per cent year-on-year growth. This was in line with the full fiscal year 2013 growth of 4.3 per cent. Such key sectors as textiles, food and beverages as well as fertilisers continue to show a rising trend in output.

Obviously, pro-growth sentiments in these and other corporate sectors would be depressed by such a sudden, unexpected and quick reversal of the easy monetary policy.

“The central bank should have kept the rate intact and allowed some space for economic growth,” says the chairman of a large group of companies with stakes in food processing, edible oil and cement. “This sadly lends credence to fears expressed by eminent economists like Dr Hafiz Pasha, that the current IMF lending programme would lead the Pakistani economy to stagflation. I’m disappointed.”

Monetary easing in FY13 had helped reduce corporate and consumer sectors’ loan infection ratio from 17 to 15.8 per cent and from 18.1 to 15.6 per cent respectively. Many industries had also retired their old expensive loans and replaced them with new cheaper ones. And consumer financing had also started to recover.

Now, as the SBP’s monetary policy tightening is set to push up borrowing rates again, what will happen? Will companies borrow less from banks or will they have to live with a higher cost of borrowing that will eventually make their products costlier? And will this not affect the recovery in consumer credit demand?

The argument forwarded by central bankers is that the increase in interest rates will force the government to borrow less from the banking system, thereby freeing up space for private sector borrowing from banks. But government borrowing from banks is normally less-inflationary than it’s borrowing from the SBP. So, in order to contain inflation expectations, the government will have to drastically reduce its borrowing from the SBP.

The federal government has borrowed Rs636.7 billion from the SBP in just two months of FY14, part of which was used to retire Rs381.6 billion worth of commercial banks’ credit.

“Based on this, and given the low growth in tax revenue and the continued financial bleeding of state-run organisations, it’s realistic to say that the only way by which the government can reduce its borrowing from the SBP in the coming months is that it will restart heavier borrowing from banks,” says a former central banker. And this would again crowd out the private sector.

“So, the argument that higher interest rates will dissuade the government from borrowing from commercial banks and thus free up space for the private sector appears weak. Besides, the SBP bosses conveniently forget that in addition to the crowding out factor, banks’ reluctance to lend generously to the private sector has also been a key reason for low private sector credit off-take in recent years.”

A more debatable point is this: doesn’t higher government borrowing from banks and consequently higher spending in productive or development areas, including bailout packages for state-run organisations, help in economic expansion? And if this is so, won’t monetary tightening at this stage hurt economic growth sentiments?

The letter of intent written to the IMF while seeking the new $6.7 billion loan had indicated that during the initial period of the loan tenure of three years, Pakistan will have room for pursuing an accommodative monetary policy, and the policy tightening may be seen at a later stage.

But in an interview published in the IMF Survey, the IMF’s mission chief for Pakistan, Jeffery Franks, had said that the implementation of the reforms programme agreed upon with the Fund “will require some tightening on both the fiscal and monetary sides to put the fiscal position on a sustainable path and reduce inflation”. He had also said that “growth may slip a little bit in the first year of the programme (FY14) because of necessary fiscal adjustments.”

Many stockbrokers and businessmen see the latest SBP move to increase the policy rate in the light of the IMF’s lending programme, though bankers say that under the current economic scenario, the policy rate hike makes sense.

“A modest monetary tightening at the initial stage of the economic reforms (agreed upon with the IMF) is an appropriate signal to the financial markets. The rate hike doesn’t necessarily tell us at this stage whether, or how much more, tightening would follow. It only signals that the phase of monetary easing is over now,” says the treasurer of a large local bank.

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