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‘Immaculate inflation’

August 18, 2012

THE two sharp cuts in the State Bank of Pakistan’s policy rate in less than a year has surprised financial analysts while it has been welcomed by trade and industry.

Analysts argue that interest rate cuts would not stimulate investment without addressing structural imbalances, containing fiscal deficit and curbing inflationary expectations.

On the other hand, the business community has hailed the rate cut as its principal lobby — the manufacturing sector — has long maintained that interest rates along with severe energy shortage are the two main culprits that stand in the way of private investment. The rate cut has helped renew somewhat the confidence of the business community.

However, there is an impression that the policy rate cut has been managed by Islamabad to reduce the government’s debt service costs. So, the interest of the business community and the government seems to converge while the financial sector stands alone.

Being the largest single borrower with fast rising bank investment in the risk-free government instruments, the ministry of finance should be asking the legitimate question: Why should it pay high interest rates on T/bills and Pakistan Investment Bonds particularly when there is no serious competition from the private sector borrowers ? And do not the banks adjust lending rates, making them commensurate with risks. For example, big importers, providing bulk business, get bank credit at much cheaper rate than the prevailing market rates.

Over the past few years, banks have been averse to lend to the private sector, fearing risks in a sluggish economy. The disproportionate investment made in government instruments have led many to question the ongoing destabilistion of intermediation process- deposit-taking and lending.

According to anecdotal evidence, many businesses are shying away from taking bank loans because of the volatility of interest rates. The high interest rate also contributes to banks’ inefficiency as the spread between average deposit and average lending rate in Pakistan is one of the high- if not the highest in the region. While the banks link lending rates to inflationary ‘expectations’, they make profits at the expense of the small depositors. The rate of return of deposits is negative when inflation is accounted for and the number of bank depositors is declining.

In view of low interest rates prevailing all over the world, the industry and trade representatives argue that the interest rate should be reduced to a single digit to cut their costs and make domestic productivity and exports globally competitive.

Coming back to the view of the financial analysts that investment would not pick up unless structural weakness are removed. Of course, they generally refer to IMF prescribed reforms. Past’s history shows that only once Islamabad availed the entire committed amount from the Fund. It happened with the first IMF loan which was disbursed in one installment. Later, all successive governments, without exception, left the IMF programme halfway. They included the last military-led regime in which a former Citibanker Shaukat Aziz was the prime minister and finance minister of Pakistan.

But government is not the only one that brings about vital structural changes through reforms. Economic development brings about radical structural changes, destroys or weakens some segments of the economy, often on whose debris a new edifice is built. While over the past sixty years no serious land reforms were carried (barring the mild efforts of former President Ayub and former Prime Minister Bhutto), and the landed gentry is still virtually exempt from income tax.

But President Ayub’s development decade brought about a transformation of the economy , of course, by bringing in reforms which created business confidence, suited the country’s soil and stimulated industrial activity. He ended up by writing a book “Friends, not Masters.’

Finally, the current multiple financial and economic crises ( systemic and cyclic) are serving as a catalyst for correcting global structural imbalances. The over- stretched banking system in richer Western countries are awash with funds ( because of monetary easing and support provided by taxpayers money). The banks are keeping their money with the central banks and not lending. The situation is similar to that in Pakistan. Things will not stay put in a vacuum. The vacuum will provide space to new economic agents. They have IT as their tool to help them.

While financial analysts oppose policy rate cuts or sharpcuts for fear of hike in energy prices and expanding fiscal deficit fueling inflation, businessmen say that inflation is a supply side problem. Constraints on investment and production should go. Economic growth should get the top priority as in China.

Then an American Karl Smith has come up with a new term ‘immaculate inflation’, as quoted by Paul Krugman in his book ‘End Depression Now’. Despite huge monetary easing and enormous fiscal deficit, the inflation rate in the US is just at two per cent. The money received by the banks is going into the US Fed reserves and not much in lending restricted to chosen customers. In Pakistan the robust corporate earnings, not finding enough productive outlets are being invested at a more rapid pace in government papers. And non-bank financial institutions are borrowing funds from banks to invest in government securities.

There is need to see how much of the money is going into supply and demand system ( of goods and services to inflate prices) to evaluate how realistic are inflationary expectations. The issue cannot be left to the mere perception of the financial market.

Now to come back to rising fiscal deficit, largely financed by domestic rupee debt. It would not be so difficult to manage when the economy is put on the fast track. The debt-GDP ratio would drop automatically. Pakistan is not like Greece which is without a national currency and burdened with debt in euros.

The entire government spending (whether productive or unproductive) is income for all those who are its beneficiaries. This is evident from the way GDP is calculated by experts and economists. The actual government spending, and not the output it generates, is treated as part of national income. Then substantial amount of money is going to sustaining public sector –led economic activities (PIA, Steel Mills, utlility companies) which cannot be allowed to collapse nor can they be currently privatised without serious economic and social costs.

The cut in interest rates would reduce expense on debt servicing and create some fiscal space to upgrade social and physical infrastructure in order to increase efficiencies in the economy and boost growth. With low private sector borrowings and investment, the governments cannot afford to let the economy slide.

Nor is the revival of the economy enough as the existing economic model cannot produce enough jobs to take care of the growing number of unemployed. The mandate of the State Bank of Pakistan needs to be broadened to target inflation, economic growth and unemployment.