Interest rates that started rising last year are all set to keep moving up during this year also - and the rupee that began to fall last year looks may decline further after making some quick recoveries.

In the interest rates region, the most important development that took place during the outgoing year was the introduction of KIBOR-based pricing for corporate loans. This put Pakistan at par with developed financial markets where corporate loans are benchmarked with the inter-bank interest rates.

Gradually the tenure of KIBOR-based pricing was extended up to one year and in less than a year KIBOR or Karachi Inter-bank Offered Rate became popular with the banks as well as corporate borrowers for determining a market-based mark up.

In a sharp contrast to this, banks failed to introduce prime lending rates needed to translate the shifting signals in the State Bank monetary policy into the interest rates structure of the banking system.

Whereas KIBOR also reflects to some extent the changes in the SBP monetary policy but its scope is limited because market liquidity and liquidity management decisions of the banks matter more in case of KIBOR than the monetary policy signals do.

Besides, since KIBOR is the average asking price of the loans to be made by one bank to another, it has nothing to do with the banks lending to corporates. That is why when banks quote KIBOR-based prices for loans to their customers, it is the premium they demand over KIBOR, and not KIBOR itself that really takes into account the credit worthiness of the borrower and the prospects of loan recovery or default.

On the other hand, prime lending rates being the lending rates of commercial banks for top borrowers do reflect the credit worthiness of particular borrowers and as such serve as a better benchmark than KIBOR for other corporates to project pricing of bank loans.

Besides, when a central bank does change its monetary policy it normally observes movements in banks prime lending rates to see if they are translating its monetary policy signals into changes in real interest rates structure.

In next door India, the concept of prime lending rates has taken roots and banks and corporates agreeably use prime lending rates as benchmark for pricing loans for majority of the borrowers.

Senior bankers have been working on the concept of prime lending rates for a couple of years and indications are that these rates may be introduced sometime next year. If that happens, corporates would find it easier to project pricing of bank loans.

Besides, when prime lending rates will be in use for pricing loans for all customers, banks would see a tougher competition between them for keeping their cost of financial intermediation as low as possible.

In the first part of 2004, interest rates remained low but with the start of new fiscal year from July the rates started moving up as the central bank accelerated gradual tightening of treasury bills rates to fight inflation.

Weighted average lending rates on fresh loaning made after June 2004 kept rising throughout the second half of the outgoing year but the overall average lending rates remained low. The reason that the stock of low-priced loans made in two years before June 2004 was much larger than the stock of fresh loans made afterwards.

However, the gradual tightening of treasury bills rates by the SBP were reflected more in KIBOR than in the weighted average lending rates of banks for the simple reason that changes in T-bills rates have an immediate impact of the interest rates and liquidity management of banks on day to day basis.

So, whereas weighted average lending rates of banks showed only a modest rise, and that too in case of fresh lending after June 2004, KIBOR showed a steeper increase.

Within less than six months to December 15, 2004 six-month KIBOR shot up to 6 per cent from 2.97 per cent at the end of June. This in turn, raised the cost of KIBOR-based borrowing to 7-8 per cent from 4-5 per cent.

Based on the 2004 experience, it is safe to assume that KIBOR would continue to rise as the central bank is likely to tighten interest rates further to fight inflation that, the SBP says, may rise by 7.6-8.2 per cent in fiscal year July-June 2004-05 against the target of 5 percent.

KIBOR would rise also because while tightening the interest rates through allowing a gradual increase in T-bills rates, the central bank would make an attempt to keep soaking excess liquidity from the inter-bank market through open market operations. The SBP did this successfully in the outgoing year, and there are reasons to believe that it would continue doing so also in the next year.

Another thing that would keep interest rates high in the next year is that internationally central banks have been tightening monetary policies and drying up excess liquidity to check inflation. London Inter-bank Offered Rate(LIBOR) for six months rose to 2.71 per cent on December 15 from 1.94 per cent at the end of June.

A noteworthy development in the interest rates regime in 2004 is that despite a gradual tightening of the interest rates, the demand for private sector credit remained strong in the second half of the outgoing calendar year or the first half of the current fiscal year.

Private sector credit off-take reached Rs189 billion in about five and a half months of this fiscal year against the full year indicative target of Rs200 billion.

The private sector credit off-take shot up despite the fact that export finance rate or the mark-up charged on concessional export loans rose by 300 basis points to 5 per cent in seven months to December 2004.

To combat inflation, the SBP would try to keep credit growth from shooting up by further increasing the treasury bills rates That may make export financing more expensive next year.

On the external sector, the most important development in 2004 was that the rupee lost 5.5 per cent of its value within first four months of the current fiscal year i.e. between July-October 2004.

Since the rupee depreciation did coincide with progressive increase in international oil prices, the State Bank started selling dollars to banks for oil imports from November 1 2004.

It also regulated the inter-bank market more strictly to check speculative activities of some top banks and business houses to ensure that the rupee does not fall beyond a certain level.

These efforts paid dividends and the local currency recovered 2.7 per cent of its lost ground in November. It made another modest recovery of 0.3 per cent in December thus keeping its actual loss against the dollar in July-December to 2.5 per cent.

In the outgoing year, the balance of payment position deteriorated chiefly because a huge trade deficit offset gains in other areas of the current account. Trade deficit more than quadrupled to $2 billion in July- November 2004 from only $444 million in a year-ago period.

The trade deficit is likely to widen further next year because imports are growing too fast. SBP has estimated in its first quarterly report that the country may see a trade deficit of $4.8 billion in the current fiscal year.

But as the trade deficit is growing on the back of increased imports of machinery, fuel oil and other raw inputs and raw materials of the industry, the economy looks set to grow smartly.

State Bank has forecast that the economy may grow by 6.5-7.1 per cent during this fiscal ending in June 2005, against the target of 6.6 per cent. However, an unusually large increase in imports of inputs used in the industrial sector pushes up imported inflation and that ends in jacking up overall consumer inflation.

That is where the State Bank finds it difficult to strike a balance between the need to keep interest rates low to fuel economic growth and the need to contain inflation by raising interest rates. Besides, imports become more expensive by allowing a fall in the rupee value.