The latest shock delivered by the State Bank of Pakistan (SBP) by raising the costs of borrowing to 15 per cent, the highest since 2008, in an attempt to cool the economy and tackle 13-year high inflation has spawned a debate because of its potential impact on businesses, future investments, exports and government debt. Consequently, the discount rate is now at 16pc, the highest since July 1998.
In addition to boosting its benchmark policy rate, the bank has increased the costs of the subsidised export refinance and long-term loans for machinery by 2.5pc and 3pc to 10pc. The bank has already linked the interest rate on these loans to its policy rate to strengthen monetary policy transmission while continuing to incentivise exports by offering a discount of 500 basis points relative to the policy rate. At the start of 2022, the export refinance rate was 3pc and Long Term Financing Facility (LTFF) was at 5pc.
Most of the financial sector and other stakeholders were already anticipating a hike in the face of persistently high global energy prices, the abrupt ending of fuel subsidies and the need to control demand after the SBP said in its last policy statement the economy had rebounded much more strongly than anticipated.
“This combined action continues the monetary tightening underway since last September aimed at ensuring a soft landing of the economy amid very high growth in the last two years, multi-year high inflation, record imports, as well as an exceptionally challenging and uncertain global environment,” the SBP says. Besides, the action should help cool economic activity, prevent a de-anchoring of inflation expectations and support the rupee, it added.
The hike in interest rates will significantly increase the debt burden of the government and the costs of its servicing but it cannot control supply shock driven inflation
Against this challenging backdrop, the Monetary Policy Committee (MPC) noted the importance of strong, timely and credible policy actions to moderate domestic demand, prevent compounding of inflationary pressures and reduce risks to external stability.
Many analysts and businessmen suspect that the SBP decision is driven mainly by the consideration to meet the International Monetary Fund (IMF) conditions rather than just targeting what Bloomberg has recorded as Asia’s second-fastest inflation, questioning its utility in containing imported inflation caused by elevated global energy and food prices. Not only that the bank has raised its policy rate it has also kept its options of boosting the rates in its next MPC meeting scheduled for August as well.
The SBP expects the deal with the IMF to close very very soon, unlocking additional funding from external sources and ensuring that Pakistan’s external financing requirements are met in 2022-23. “The pressures on rupee will also moderate then and SBP foreign exchange reserves would also resume their upward trajectory,” the SBP says.
The latest rate hike takes the total increase to 525bps so far this year. “The goal of this decision is to moderate demand pressures, anchor inflation expectations and stabilise the rupee,” says Fahad Rauf, head of research at Ismail Iqbal Securities.
“I think this is an IMF-directed decision. There is no forward guidance as such, which means that the SBP wants to keep the option open for further hikes. Although this should be the last adjustment agreed with IMF.” In his view, the boost in the costs of borrowing will hurt working capital funding for exporters while also discouraging new investments in machinery.
“How fair is it for the SBP to delay import of parts, thwarting operations of industry and to slam it with a higher policy rate? How fair is it for Finance Minister Miftah Ismail to super tax industry to save Pakistan from defaulting and then find the provinces not according with IMF conditions?” asks the Pakistan Business Council (PBC), a body representing major Pakistani and foreign corporations, through a tweet.
With the economy slowing down and the impact of fiscal measures like a reversal in energy subsidies yet to be reflected in economic indicators, Mr Rauf argues that the SBP has probably gone a little bit far with tightening looking at past numbers on different industries.
“These numbers will be very different in the coming months. The boost in the rates (at this stage) is bad as the supply shock driven inflation cannot be controlled through interest rates.
“Interestingly, SBP agrees that there is a dampening effect on demand-pull inflation but still targets to chase supply shock driven inflation readings from the reversal of energy subsidies. The hike in interest rates will only raise the borrowing costs for businesses, especially exporters. The investment will be discouraged as LTFF rate is also enhanced.”
The SBP expects inflation to remain elevated at current levels of 18-20pc in 2022-23 while dropping to the target range of 5-7pc by the end of 2023-24, mainly due to the normalisation of commodity prices, base effect and tight policies. Also, the economic growth rate this fiscal year is expected to come down to 3pc from 4pc on account of monetary tightening and fiscal consolidation.
“With non-food non-energy inflation at 11.5pc, a policy rate increase is unjustified. Food and energy cost inflation is itself a demand depressant. The policy rate increase could lead to recession and unemployment. The decision to raise the policy rate to 15pc will hurt the government, the formal private sector and exporters, also suffering from the gas shortage. It will do nothing to stem cost-push inflation or imports. Wake up — recession and unemployment are the real risks,” the PBC warns.
Asif Ali Qureshi, CEO of Optimus Capital Management, says the increase in interest rates will significantly increase the debt burden of the government and the costs of its servicing. “Almost 80pc of government’s Rs29 trillion debt at the end of May this year was either T-bills or floating rate bonds that reprice quickly. So the government will be impacted the most from a further increase in interest rate,” he contends.
Published in Dawn, The Business and Finance Weekly, July 13th, 2022