TARGETING interest rates has become increasingly popular throughout the capitalist world, including Pakistan, since credit planning was abandoned in 1993. The central bank primarily uses variations in interest rates through frequent open market operations to stimulate or stabilise the macro economy.

A recently completed CBM study shows that this policy is quite ineffective. Aggregate demand for money (M2, M3) does not respond to changes in interest rates.

The theory is that when the SBP changes the policy rate — announced every two months since 1999 — it would produce corresponding changes in short-term Treasury bill rates, money market rates, bank deposit and lending rates and interest rates on National Savings Schemes (NSS). This transmission of policy rates to all other interest rate changes is known in literature as the interest rate channel.

The conventional wisdom is that an across-the-board rise in interest rates will raise total savings and reduce investment. A change in savings and investment will have an impact on output and employment growth and on the aggregate price level.

‘Excess liquidity in the money market reduces policy rate effectiveness and dampens the pass-through effect’

But if the SBP’s policy rate changes do not ‘pass through’ to other interest rates in the money and loan markets, then this would not happen. The question is, do the SBP’s policy rate changes pass through?

We used standard econometric techniques — regression analysis, co-integration techniques and granger causalities — to estimate the relationship between changes in the SBP policy rate and money market rates, deposit and loan rates and NSS interest rates.

We used monthly data from January 2002 to December 2011 to estimate short- and long-run relationships between the SBP policy and other interest rate changes.

The results could be summarised as follows:

• A long-term relationship between the policy rate and the six-month T-bill (TB6) rate exists. They move in the same direction

• Changes in the TB6 rate had a positive effect on overnight call rates and overnight repo rates after a four-month period, for a 12pc change in both the call rate and repo rates

• Money market rates thus respond weakly and sluggishly to changes in the policy rate

• On the other hand, there is no long-run relationship between changes in TB6 and in the weighted average lending rate (WALR) and the weighted average deposit rate (WADR) at all. Changes in the policy rate and the TB6 rate do not induce commercial banks and non-banking financial companies to alter either the rate they are paying their depositors or the interest they are changing on their advances

Since aggregate savings and investment are affected not by money market transactions, which exclusively represent interbank transactions, but by changes in deposit and loan rates, it is fair to conclude that changes in the policy rate do not affect savings or investment behaviour.

Such policy rate changes can thus have no effect on growth of output or employment or on the aggregate price level in the macro economy.

Furthermore, there was no long-run relationship between changes in the TB6 rate and the rates of interest on NSS — with the exception of those on defence saving schemes, which respond to changes in the TB6 rate after a four-month period.

As far as short-term (monthly) relationships are concerned, we found a strong positive relationship between changes in the TB6 and the money market rates (both call and repo). The relationship between the deposit rate and TB6 is also strong and positive, showing that short-term deposit rates are affected by movements in the money market.

On the other hand, a rise in the policy rate does not pass through to PLS or term deposit rates. There was no relationship between the WALR and TB6 rates in the short- term.

The granger causality tests showed a bidirectional causal relationship between the policy rate and the money market and bank deposit and lending rates. This provides some support for the post-Keynesian view that monetary policy initiatives are endogenous to the operation of a typical monetary production capitalist economy.

In other words, the State Bank has been captured by the commercial banks and its policy initiatives are a response to banks’ need of profit-maximising, as reflected in their demand for money and supply of credit. Monetary policy is thus made by these profit-maximising commercial banks, and the SBP is a passive instrument in their grasp.

The dominance of commercial banks in the money deposit and credit markets also became clear when we used Gigineishvili’s methodology to identify the determinants of the pass-through function. In other words, we tried to find out why the pass-through from the policy rate to banks’ deposit and loan rates is so weak.

Gigineishvili, in his study of pass-through in developing countries, found that per capita GDP, an inflation index, credit quality, overhead costs and interbank competition facilitate pass-through of the policy rate to the money market, deposit and loan rates. But excess liquidity in the money market reduces policy rate effectiveness and dampens the pass-through effect.

However, our estimates showed that none of these variables had any impact on the extent to which policy rate changes influence changes in bank deposit and loan rates. Commercial banks do not respond to changes in macroeconomic variables; they sue monopoly power to set rock bottom deposit rates and practice such heavy discrimination between ‘favourite son’ and ordinary borrowers that the WALR and variations in it become meaningless as indicators of bank-lending policies.

The SBP promotes this banking sector monopoly in a variety of ways. Another CBM study — by Rasheed and Ansari, which focuses on the impact of monetary and fiscal policy on income distribution and poverty — shows that monetary policy in Pakistan is made by the rich and for the rich. It contributes virtually nothing to price stabilisation, output growth and income distribution improvement.

Since adopting a market-based monetary policy, the SBP has never used any measures to break financial sector monopolies. On the contrary, it has inexorably raised capital adequacy requirements, stimulating financial sector monopolisation.

There is, therefore, an ironclad case for abandoning the market-based monetary policy and for reinstituting the credit planning regime that served the country so well — in terms of efficiency and equity macroeconomic impact — during 1975-1991.

The State Bank must abandon its reliance on open market operations for controlling the money supply. It must make much more frequent and aggressive use of reserve ratios, liquidity ratios and credit-to-deposit ratios for this purpose, and impose capital controls. It must set sector-specific credit ceilings and targets, and comprehensively administer interest rate structures. It must.

Javed Akbar Ansari works at the Centre for Development Studies, IoBM, and Nabeel Latif at KASB Securities

Published in Dawn, Economic & Business, October 27th, 2014