On September 20, the State Bank of Pakistan (SBP) raised its key policy rate by 25 basis points to 7.25 per cent. Pakistan stock market’s KSE-100 index began falling. The index fell from 46,528 on September 20 to 43,883 on October 12 or 6pc within three weeks.

But it was not just the interest rate hike. Concerns regarding the finalisation of the new International Monetary Fund’s (IMF) conditions and political instability in the country also contributed to the declining trend in the stock market. A positive outcome of the ongoing negotiations with the IMF would surely help reverse this trend if political instability does not take an uglier turn. A higher interest rate would leave a nominal impact on the market, more so because the SBP is acting upon its policy of “gradual and measured” interest rate tightening to tame inflation.

Investment in sovereign debt papers in July-August this year was recorded at $976 million, according to Pakistan’s balance of payments statement. In theory, this volume should expand in September-October due to the Sept 20 interest rate tightening that has made our treasury bills more attractive for foreign buyers.

Chances for increasing non-bank borrowing through NSS are slim — the only available option for the government is to borrow more aggressively from banks

The same cannot be said, however, about long-term Pakistan Investment Bonds (PIBs) because foreign investors normally prefer short-term sovereign debt securities. In the routine auction of treasury bills immediately after the interest rate tightening, the cut-off yield on three-month and six-month T-bills had risen to 7.64pc and 7.98pc respectively, from 7.23pc and 7.49pc. (The first post-rate hike auction of Pakistan Investment Bonds is due in mid-October).

The rupee has lost about 8.5% of its value against the US dollar since the beginning of this fiscal year on July 1

This time the central bank has started gradual and measured interest rate tightening under special circumstances. The SBP had slashed its policy rates by 625 basis points, from 13.25pc to 7pc, in less than 100 days —between March 18 and Jun 26, 2020. This unprecedented interest rate slashing was aimed at boosting aggregate demand, and by extension inflation, to keep the 2019-20 recession as low as possible and to prepare the ground for a quick growth revival in 2020-21. The objective was achieved: the Covid-19 triggered recession remained slightly below 0.5pc in 2019-20 and Pakistan’s GDP grew 3.94pc in 2020-21.

But following the footsteps of other central banks of the world, the SBP while slashing interest rates had also started providing forward guidance to financial markets through its monetary policy statements. Just like other central banks it also resorted to liquidity provision, credit support and regulatory easing to provide a base for expansion in economic activity.

The only area where the SBP didn’t follow other central banks was that it did not go for direct purchases of government assets because the Pakistan government had already stopped borrowing from the central bank after bursting the ceiling set for this purpose in the past. This opened room for commercial banks to lend more aggressively to the government both for its routine requirements as well as for financing the fiscal package designed to achieve quick economic recovery.

If we keep this background in mind it becomes easier to understand that a 25bps rise in the interest rate now — amid the possibility of further gradual and well-measured increases in the rate — would not have a substantial impact on the stock market. Financial markets factored it in right from the beginning of the issuance of the forward guidance signals by the SBP.

Key fundamentals of the stock market like corporate performance and dividend yields would weigh more decisively on the market than the increase in interest rates in small doses.

Theoretically higher interest rates translate into an increased cost of production for firms thereby affecting their ability to earn enough profits and offer enough dividends. But under the present circumstances, this does not hold true for a large segment of our corporate sector that continues to enjoy the concessional credit package offered in the wake of the Covid-19 pandemic. Smarter firms are rather likely to replenish their retained savings after the interest rate hike only to draw down on them at the time of need.

An increase in bank deposit rates post interest rate hike is certain. But the increase would be nominal, in line with the exact increase in interest rate. The weighted average return on fresh deposits (excluding zero-markup deposits) stood at 5.68pc. When more recent data becomes available one can see this average return rising close to 5.80pc — not more than that unless the SBP further increases its policy rate.

Will the Sept 20 interest rate hike help the government borrow more from banks with higher yields on treasury bills? Yes. But will it also attract more investment in long-term PIBs? Yes, but only domestically — and that too by banks and financial institutions. Domestic corporate savers have little appetite for PIBs and for foreign investors, short-term T-bills are the darling. Between July 1 and Sept 24, the federal government had borrowed only about Rs289 billion from banks, SBP data show.

When more recent data is released, one can expect this amount to rise fast as yields on T-bills through which the government makes the bulk of bank borrowing have already risen sharply in the secondary market.

One can expect much stronger government borrowing from banks in the Oct-Dec quarter because the first quarter borrowing traditionally remains low. And this time around the fall of the rupee — and low public interest in national saving schemes (NSS) — has enhanced the government’s need for bank borrowing.

In less than three-and-a-half months the rupee has lost 8.9pc value against the greenback, coming down to 171.13 per dollar on Oct 13 from 157.54 on June 30. This has increased the cost of external debt servicing in rupee terms, disturbing budgetary allocations for it.

Chances for increasing non-bank borrowing through NSS are slim. The only available option for the government is to borrow more aggressively from banks.

Published in Dawn, The Business and Finance Weekly, October 18th, 2021

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