Private investment has a sensitive relationship with the policy rate, the primary tool for central banks to rein in inflation and defend the currency. This means that a higher cost of credit can have a detrimental impact on private investment. Typically, higher rates drive down private investment spending and lower rates boost it.
So, it is common for central banks to cut the policy rate to drive up investment when the economy is slowing and requires investments to increase domestic productivity and create jobs. Therefore, you often find businessmen and investors arguing earnestly against real (or inflation-adjusted) interest rates, especially in times of high inflation.
It was, thus, not surprising that the businesspeople felt quite disappointed when the State Bank of Pakistan (SBP) decided to keep its key rate unchanged at 13.5 per cent in its last monetary policy meeting on September 17.
Data for the last 19 years indicates that investors have not always responded eagerly to lower rates nor have higher rates kept them from investing
This argument advanced by investors in favour of lower interest rates anticipates a linear relationship between the key policy rate and private investment. But, in the context of Pakistan, it doesn’t appear to be supported by evidence. The interest rates in Pakistan have historically remained very high — in double digits most of the years, peaking to 20pc in 1996. The low rate periods have usually been intermittent and brief.
A look at the data on the changes in the policy rate and the increase or decrease in private Gross Fixed Capital Formation (GFCF) for the last 19 years indicates that the investors have not always responded eagerly to lower rates. Nor have higher rates kept them from investing their money in the economy. This suggests a rate hike or reduction does not necessarily pull down or push up private investment spending.
The private investments to GDP, for example, spiked to an annual average of 15.3pc between 2005-06 and 2007-08 although policy rate in those years was hiked from 9.0pc to 12pc.
On the contrary, when the policy rate dropped to a historic low of 5.75pc during the three years between 2015-16 and 2017-18, the private investment stagnated at 10.3pc. Similarly, the reduction of 150 basis points in policy rate from 9.0pc to 7.5pc in November 2002 couldn’t induce a major change in the investment levels, which stood at 11.3pc in 2002-03 and 2003-04 before rising to 13.1pc in 2004-05. This was in spite of the fact that the rate remained flat and unchanged for almost three years.
Such nonlinear trends in the relationship between real policy rates and investment decisions do not undermine the argument that higher credit cost can and does dampen investment sentiments. Instead, these underline that the interest rate, although an important factor, is not the only determinant that affects the investment decisions; several other variables — such as business confidence, energy availability and affordability, political stability, macroeconomic uncertainty, inflation, tariffs, taxation, factors related to ease of doing business, and so on — also play an equally vital role in swaying the investment decisions of the private sector.
The spike the country saw in private investment in the mid-2000s was led by massive expansion by the textile industry because of the elimination of the textile quotas from the start of 2006. The private investment stagnated under Pakistan People’s Party on account of severe energy shortages for the industry and rising global oil prices, and under Pakistan Muslim League-Nawaz primarily because of energy affordability.
There is no denying the fact that the currency crisis and the spike in policy rate that rose from 7.5pc to 13.25pc in a little more than a year has dampened investment sentiments, slowed down the economy, forced investors to hold back on their expansion plans and impacted negatively on employment. But a rate reduction, no matter how large it may be, is no guarantee that investment will kick-start as some would like us to believe.
The business community’s contention against the current policy rate level is based on three arguments: first, the present price inflation is cost-pushed, which has resulted from the exorbitant increase in energy (electricity, gas and fuel) prices, new taxes, documentation drive, steep exchange rate devaluation, etc. This argument suggests that the central bank’s policy response in the shape of higher interest rates is unlikely to tame it; rather it is forcing industrial shutdowns, production cuts and job losses.
Second, they contend that the central bank should base its policy rate decisions on core inflation numbers instead of the headline CPI (consumer price index) numbers. (If this was the case, the real rates would automatically dive significantly).
Third, they insist that the economy direly needs massive investment stimulus from both the government and the private sector to break out of the present economic slowdown.
Indeed, ongoing demand compression due to the SBP response to the imbalances is causing hardship for the businesses. But its monetary policy that is targeting the future inflation expectations (perhaps for first time in many years) rather than basing the real rates on past data is producing results.
The currency has stabilised and the current account deficit has significantly reduced. Even inflation expectations are moderating from the annual target of 13pc to 11-12pc. A digression from this policy for immediate, short-term growth can lead the country back into economic chaos.
The continuation on this path at least gives one hope that the real rates will push investment and growth in the long run by containing inflation, ensuring exchange rate stability and encouraging people to save more (for higher returns), which, in turn, makes more funds available for private investors to borrow for their projects.
Published in Dawn, The Business and Finance Weekly, September 30th, 2019