The SBP should not hold back

March 14, 2016

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At 6pc, Pakistan’s key policy interest rate is the lowest in recent memory. In the case of subdued inflation, the policy rate represents large transfer of wealth from the country’s largest borrower — the government — to the country’s lenders primarily its banks.

The rate is too high to stimulate growth through private sector credit expansion, and hurts export competitiveness by supporting an overvalued currency.

For the current fiscal year, the Ministry of Finance has budgeted over $11bn for interest payments on domestic debt. To put that in perspective, that’s 75pc of the total amount of tax revenue the federal government expects to collect this fiscal year.


Currency weakness and inflation are both things that Pakistan could do with a bit of


Meanwhile, banks still have limited incentives to lend to the private sector — as evidenced by the percentage of government paper on their books. Those who claim that the reason for low private sector debt uptake is lack of demand ignore the fact that high real interest rates are likely a key culprit.

The SBP, in its annual report for last year, acknowledged this, with a comparative study of real interest rates over three years in Pakistan and regional peers, highlighting that high real rates were a primary cause for low credit off-take.

The recent easing has led to a significant increase in private sector borrowing. There should be little doubt about the strong causal link, and the likely impact of reducing rates further.

More broadly, our GDP growth rate, while accelerating, is still well below regional peers.

And finally, our exports have plunged due in large part to an overvalued exchange rate. That’s the bad news.

The overwhelming majority of our domestic debt burden is short-term floating rate debt. For the current fiscal year, the government has budgeted that nearly $80bn of floating rate debt will be ‘rolled over’ and be repaid with the proceeds of new short-term debt. It is for the central bank to decide what interest rate to pay on new debt. And the answer to that question should be lower and lower still.

Faced with a lower policy rate, banks, broadly, will have three options. Lowering the rate paid to domestic savers goes hand in hand with all of these.

Firstly, the banks can continue lending the same amount to the government. If the debt stock remains constant, a 2pc cut by SBP means annualised savings for GoP of $1.6bn. This saving comes from bank shareholders and domestic savers.

Secondly, they can increase lending to the private sector. This is a good outcome, and is the mechanism by which low rates can translate into economic growth just as the political/security situation is stabilising.

In the case that private sector lending increases at the expense of government lending, the government may have to turn to foreign currency sources for some portion of the required borrowing that cannot be sourced domestically.

A more dramatic, but likely more effective option (though one likely to invite the ire of the IMF), would be for the central bank to buy the government debt that the private sector no longer buys (effectively, to print money — not such a terrible idea with still sluggish growth and low inflation). And finally, heaven forbid, the government can try and increase tax collection to plug the gap.

The third option for domestic currency investors, somewhat theoretically (because of capital controls), is that they can invest overseas (or remit less), and thereby cause currency weakness. Which again, is just needed for Pakistan.

In reality, what is likely to happen if the policy rate were to be cut another 2pc or so, would be a combination of all the things mentioned earlier. This would be similar to what we have seen throughout this round of easing. Banks will replace some government lending with private sector lending, while continuing to lend the lion’s share to the state. The government’s servicing burden on the balance will be much lower than budgeted, arresting the wealth transfer from an already impoverished government to not-so-impoverished bank shareholders.

The amount by which bank lending to the government is reduced will be made up for by a mix of higher revenue collection, long term foreign borrowing, and hopefully a bit of central bank buying. Inflation will pick up as a result, and the currency will weaken. But growth will accelerate. Employment will pick up.

The reason that this is the right time for the State Bank to be bold is that the risks typically associated with expansionary monetary policy, and also highlighted by the SBP. Currency weakness and inflation are both things that Pakistan could do with a bit of.

The risks of not acting are high — for the first time in years, the political and security environment is highly conducive to accelerated growth. It would be right time to complement that with aggressive monetary policy. And rates, once set, are not set in stone … they can be reversed if currency depreciation and inflation begin to exceed comfort levels. But for now, we need lower and lower still — don’t hold back.

The writer is the CEO, of Elgin Road Partners, a financial services startup. The views expressed are his own.

Published in Dawn, Business & Finance weekly, March 14th, 2016