STOCKS soared, the benchmark Karachi Interbank Offered Rates declined, and returns on Treasury bills and Pakistan Investment Bonds slumped after the State Bank of Pakistan cut its policy rate by a full percentage point on January 24.

The KSE-100 index went up 440 points on January 26, the day the SBP’s reduced overnight lending and borrowing rates — 8.5pc and 6pc respectively — became effective. The benchmark six-month Kibor fell to 8.6pc from 9.07pc, and T-bill and PIB yields were markedly down in the secondary market. And in an open market operation on January 29, the SBP injected Rs142bn into the banking system at just 8.3pc for one day.

In a meeting with heads of banks on January 26, SBP Governor Ashraf Wathra told them to exploit the post-policy rate cut market conditions by increasing their lending to the private sector. The meeting, also attended by senior SBP officials, noted that the monetary transmission mechanism has improved in recent years, making it easier for banks to behave rationally after adjustments in the policy rate, bankers said.

The business community has generally hailed the rate-cut, which is expected to promote banks’ private sector lending and make bank loans cheaper for the government.

In the six-and-a-half months of this fiscal, banks’ lending to the private sector declined to Rs161bn, from Rs246bn in the same period of the prior fiscal year. However, the federal government’s borrowings from banks during July 1, 2014 to January 16 jumped to Rs696bn, against a net credit retirement of Rs47bn in the year-ago period, SBP’s latest statistics reveal.

The government used the bulk of the funds to slash its net borrowing from the SBP to a negative Rs392bn in the period under review, from Rs745bn in the same period of the prior fiscal.

Anticipating a policy rate reduction, banks had started lending to the government at low rates in the T-bill auction held before the January 24 move. Just five days before the monetary easing announcement, banks accepted a 19bps drop in the weighted average return on six-month T-bills from the previous auction.

“Lower oil prices and an expected improvement in the current account, in addition to cheaper bank borrowing after monetary easing, should help contain the fiscal deficit to some extent,” said a finance ministry official

Now, with the rate-cut effective, they would have no choice but to accept even lower yields on T-bills and PIBs. One indication of this came during the January 28 bidding at the PIB auction, where banks demanded 8.84-9.06pc yield on three-year PIBs.

This declining trend in T-bills and PIBs rates would help the government contain its cost of domestic debt servicing. Conversely, it will reduce the interest income of banks, whose crave for government securities is well known. “So, the way forward for banks is to lend aggressively to the private sector and to increase their non-interest incomes,” says a central banker, adding that this is exactly what the SBP wants banks to do.

However, bankers say their most immediate worry relates to two things. The first is over how to keep banking spreads low — as directed by the SBP chief in his recent meeting — and the second is over how to boost private sector credit when demand is coming from just a few sectors.

Banks’ average spreads continue to remain high, SBP Governor Wathra had told bankers, and called upon them to rationalise the spreads reasonably. The SBP has decided to review banks’ spreads by this June, and it ‘may take regulatory measures’ to lower them, he had warned.

By end-December, the average banking spread was 4pc, based on 11.3pc fresh average lending rate (minus zero-markup, minus interbank) and 7.3pc fresh average deposit rate (minus zero-markup, minus interbank).

The decline in inflation to 6.08pc in 1HFY15 from 8.89pc in 1HFY14 and the possibility of a further fall due to plummeting oil prices and a halt in the government’s borrowing from the central bank, means that banks’ minimum deposit rate (MDR) — now at 6.5pc — would remain positive. The rate would look even better given the annualised monthly inflation of 4.3pc in December.

Under this situation, anything offered to bank depositors beyond the MDR should enable banks to expand their deposit bases. This also puts to rest bankers’ fears about what would happen to their deposit-mobilisation efforts in an era of lax monetary policy.

“Similarly, they can test the genuineness of their worries about credit demand by lowering their lending rates in line with the policy rate cut,” says a senior central banker.

“Quite often, it is not low sectoral appetite for loans but banks’ reluctance to accommodate the credit demand that results in slower loan distribution.”

The recent cut in the policy rate has come at a time when global oil prices dropped 60pc in about seven months, and when our current account looks set to improve due to lower oil imports, strong double-digit growth in remittances, rise in foreign investment, launch of dollar bonds and continuing IMF lending etc.

“From the government’s perspective of domestic debt management, it’s an opportune time,” says a finance ministry official. “Lower oil prices and an expected improvement in the current account, in addition to cheaper bank borrowing after the monetary easing, should help contain the fiscal deficit to some extent.”

Published in Dawn, Economic & Business, February 2nd, 2015

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