As the economy shows some signs of resilience after two policy rate cuts since June last year, a case for reinforcing signals for lax monetary stance is building up.

Between July 1 and November 16 this year, banks lent Rs52 billion to the private sector against a net credit retirement of Rs9 billion in the same period of last year as decline in interest rates pushed up credit demand by private sector businesses.

However, businessmen fear that if the central bank decides to hold its policy rate in its December review of monetary policy, it would depress fresh credit demand, thereby disturbing a recent recovery in some industrial sectors and limiting the scope of the spillover effect of decent agricultural growth.

According to the latest State Bank statistics, bank loans to the private sector recorded an increase of just Rs40 billion in one year to October 2012 but their investment in non-bank financial institutions (NBFIs) witnessed a big rise of Rs88 billion during this period. This year-on-year comparison is helpful in analyzing lending behaviour of banks in a falling interest rates regime. In October 2011 SBP policy rate was at 12 per cent which remained unchanged till June 8 this year when the central bank cut it to 10.5 per cent and then to 10 per cent on October 8, 2012. So the point is this: banks are passing on benefit of the rate cut more to NBFIs and less to private sector businesses.

This trend can be reversed if the central bank eases its monetary policy further and effective lending rates for business continue to decline, creating more private sector demand for bank credit.

As government borrowing has started declining, chances are that banks would begin to lend more to the private sector, thus playing a helpful role in revival of industrial output and economic growth.

Between July 1 and November 16 this year, the federal government’s borrowings from banks fell to Rs477 billion from Rs623 billion in the same period of the last year. This happened as the budget deficit in the first quarter was contained at 1.2 per cent of GDP and the government’s non-bank borrowings through National Savings Schemes in the four months till October shot up to Rs184bn from only Rs67bn in the year-ago period.

The SBP is due to revise its monetary policy stance in the first half of December for the next two months. Central bankers are debating the above-discussed issues and several other aspects of monetary policy through in-house brainstorming sessions. More recent data will be available to them by the time the policy decision is taken.

One important feature worth observing would be the composition of private sector credit. Senior bankers claim that the composition is changing in favour of private businesses and end-November data would show that banks have started making sizable fresh net loans to the private sector.

“A change is taking place. We are lending more to businesses as bank loans have become cheaper and government borrowings for budgetary support have somewhat shrunk, creating space for banks to accommodate higher credit demand from the private sector,” opined head of credit operations of one of the top five banks.

“If this trend is really emerging (as being claimed by bankers),” says a senior central banker “it can be sustained more easily if the SBP makes another cut in its policy rate and if the government keeps reducing its bank borrowings.”

Apparently there is a case for further rate cut: Inflation has not spiked despite two rate reductions (of a total 200bps) since June; it has rather come down and there are obvious signs that the economy is doing better than before. Agriculture sector growth of 4.1 per cent looks achievable on the back of higher production of major crops; recovery is also in sight in highly leveraged industries like cement and oil and gas exploration and production; external sector performance is improving; exports have rebounded recently, the current account is in surplus, and the budget deficit in the first quarter remained low. Exchange rates have recently come under pressure as the market prepares for the second quarterly external debt payments. However, rupee depreciation has boosted exports and slowed down imports’ growth, thereby mitigating the ill-effects of monetary easing via imported inflation.

Improved performance of the external sector means greater maneuverability of the government to manage its finances and larger non-bank borrowings means reduced dependence of the government on commercial banks. These two factors combined to create room for banks to lend more to the private sector. “This is exactly what the central bank wants now to do with all its monetary policy tools including policy rate changes,” said an SBP official without specifically commenting on the possibility of another rate cut.

“A further rate cut would help in keeping the government’s domestic debt servicing cost within limits. And that would free up more fiscal space for development spending and result in reduced bank borrowing,” remarked an official of the ministry of finance involved in domestic debt management.

In the first quarter of this fiscal year, domestic debt servicing devoured about Rs300 billion or a little less than half of the total current expenditure of Rs623 billion.

But there are other equally important things that need to be taken into account. What if fuel oil prices rise further; what about accelerated expansion seen so far in both broad money and reserve money (the latter having a more direct bearing on inflation); what if further easing of monetary policy and the subsequent decline in government treasury bills rates impacts too heavily on banks’ balance sheets, and above all, why not keep monetary policy stance stable now instead of signalling further softening. Of course, the central bank would take these and many other factors including the possible impact of further easing of monetary policy on already low savings and investment rates before it decides which way to go—hold the policy rate or cut it again.

When the SBP had cut its policy rate by 50bps to 10 per cent in October some people had viewed it as too little whereas others had seen it as a clear signal to reinforce the lax monetary policy stance of the central bank (after a full-dose 150bps cut in June).

Central bankers say what is important at this stage is not the quantum of interest rate cut but a policy direction. For those in the central bank who believe in keeping a pro-growth, easy monetary policy, it is more important to further reinforce the policy signal by making just a nominal cut in the discount rate rather than going for a big reduction. And for those who think that further easing of monetary stance is not advisable even at a nominal rate.