Stable interest and exchange rates are expected to boost investment, but for this to happen, the trend of rent-seeking must be checked effectively to provide a competitive business environment.

Weighted average interest rate (on fresh loans) fell from 10.37pc at the end of FY14 to 8.24pc in FY15 and to 7.15pc in FY16—showing a decline of 322 basis points in two years. And, during this period the decline in interest rate was gradual, owing largely to a cautious easing of monetary policy. No interest rate volatility was seen.

On the other hand, exchange rates that had remained volatile till the end of FY14 also showed some stability in the next two fiscal years though the rupee witnessed a modest depreciation. The rupee fell from 98.80 per dollar at the end of FY14 to 101.78 in FY15 and to 104.83 in FY16—depicting a total decline of 6.1pc in two years. The volatility in exchange rate during these two years was contained by the timely intervention of the State Bank of Pakistan. This volatility was, however, modest, less frequent and short-lasting compared to the ones that hit forex markets in the preceding years.

Volatility in interest and exchange rates normally affects the viability of long term investments

Volatility in interest and exchange rates normally affects the viability of long term investments. Capital spending may pick up with a time lag, more so because of some structural problems of our economy.

Small wonder then that gross fixed investment only inched up from 13.4pc of GDP in FY14 to 13.5pc of GDP in FY15. Data for FY16 is yet to be released but no big rise is expected, senior central bankers say.

Volatile interest and exchange rates also often stimulate corporate capital spending and lead to the creation of fixed assets. This is because companies go for importing equipment and machinery when it becomes cheaper at times when the local currency is relatively strong vis-à-vis the dollar or other major currencies, and they borrow excessively from banks when interest rates take a dip; knowing that both the exchange and interest rates would move in the other direction after some time. In the last two fiscal years, relative stability in exchange and interest rates theoretically blocked this opportunity.

But decent growth rates of outputs of some large-scale manufacturing industries are said to have come after some capital spending and creation of fixed assets. And, in the services sector, too, some domestic and foreign investment has trickled in, according to industry sources. The lessening of energy woes and improvement of law and order situation in Karachi - the hub of industrial and commercial activities - and higher demand of certain industrial and services sector products - have spurred some investment. Capacity enhancement projects in automobiles and capital spending in telecom and IT are two key examples.

Another thing worth examining in relation to stable or volatile interest and exchange rates is their impact on foreign trade. The rise in imports can be partly attributed to stable exchange rates or somewhat modest decline in the rupee value against the dollar. A double-digit growth (about 15pc in FY15 and about 16pc in FY16) in imports of machinery points toward capital spending and creation of fixed assets by companies.

In the outgoing fiscal year, the SBP kept the monetary policy almost stable going for just 75bps cut against a gradual slashing of 300bps in FY15. This helped boost private sector credit from Rs224bn in FY15 to Rs461bn in FY16. And, according to the SBP’s July 30 press release (about its decision to keep key interest rate stable) the private sector credit accelerated for both working capital as well as fixed investment.

A spike in long-term loans for construction of buildings and infrastructure pushed up the stock of such loans from Rs52.3bn at the end of FY14 to Rs66bn in FY15 and then to Rs92.3bn in FY16 (as of May 2016).

“Regardless of how long the current spell of stable interest and exchange rates lasts, one worrying aspect is a phenomenal rise in currency in circulation on which the SBP’s silence is beyond comprehension,” laments a former advisor of the central bank.

Even in its July 30 press release issued for announcing the monetary policy stance, the SBP did not discuss the factors responsible for a surge in currency in circulation (from about Rs377bn in FY15 to Rs779bn in FY16). Analysts say that such a high level of currency in circulation may be an indication of an expanding trend in the parallel economy. “Unless this trend is checked, the gains of stable interest and exchange rates may be compromised in the short to medium term,” warns a former deputy governor of SBP.

Published in Dawn, Business & Finance weekly, August 8th, 2016