In the last two years, there has been a radical change in the management of the country’s monetary system. The change was overdue; archaic managerial style of the 1990s had damaged the economy in more ways than one.
But, like any other sweeping change, this one too has given rise to doubts because we have a tradition of applying quick fixes without bothering about their future impact.
For instance, is the monetary policy expedient or objectives-driven? Will the options being exercised resolve the issues they are intended to resolve without casting a shadow on the future of the economy? Is the speed of change realistic, given the capacity of institutions and institutional arrangements to adjust thereto? Finally, is the monetary policy stance equitable in its impact of the various economic sectors, especially the savers?
The policy stance appears to be four-fold: reform of the system to make it market-based, increase in the efficiency of market mechanism, bringing down the cost of borrowing to help government and industry cut their debt servicing costs, and improve regulation to rehabilitate the financial services sector.
Admittedly, Pakistan’s markets are going through a transition, and regulators face a mighty challenge - putting too many things right quickly enough, but it would be wise to accept that not everything can be put right overnight; steps to speed up reform must be taken with care. in this context, it is worth examining how well has the State Bank pursued its avowed objectives.
An issue to be addressed at the outset was building in-house capacity for regulation in line with contemporary needs. Sustained political interference had caused dilution of professional values among central bankers. Reaffirmation of these values was imperative for giving credence to demands for reviving State Bank’s autonomy. The Bank’s new management has addressed this issue aggressively, and must be complimented for building in-house capacity through staff re-training, induction of seasoned professionals in positions of critical responsibility, and infusion of fresh blood to sustain this process.
Due to this qualitative change in the State Bank, regulation has improved but market efficiency in terms of improved resource allocation, continues to be low. The inhibiting factor is the paucity of investment choices and credible institutional arrangements to facilitate making those choices. Even the corporate bonds market, though expanding, is too small to offer savers much variety. Besides, a sizable secondary market for bond trading has yet to emerge to assure savers about ready liquidity. But even more important is the fact that until the market is liberalised to allow trading in a variety of investment and hedging instruments, it is unlikely to become efficient. However, the intentions of the State Bank to move further in this direction hold out a welcome promise.
De-regulation has been at the core of making the economy market-based. It has improved market mechanism in terms of operational efficiency but post de-regulation instability (often witnessed in its early phases) is visible. Unlike markets with sufficient depth that don’t require frequent central bank intervention because adequacy of bids and offers exerts a self-stabilizing influence.
In Pakistan the central bank would need to intervene more often, and prudently,to stabilize interest rates in desirable bands. This is crucial for price stability and building investor confidence. Wide fluctuations adversely affect confidence and institutional profitability that eventually filters down to savers and investors. So far, the State Bank’s performance in this area has not been very convincing. Short-term interest rates continue to fluctuate widely impacting the profitability of money-centred banks, and the quality and frequency of intervention not served to counter this trend.
For instance, in the T-Bills auction on February 7, the State Bank sucked up the entire market liquidity (reportedly, to punish rate-speculation by big banks) when it accepted all bids adding up to an historic Rs24.776 billion at a weighted average return of 6.583 per cent per annum. Sucking up so much liquidity was not prudent. Thereafter, banks lined up for discounting securities amounting to as much as Rs20 billion a day at a cost of 9 per cent per annum until the State Bank injected over Rs18 billion back into the market.
Admittedly, reckless bidding by banks was to blame for the fiasco, but absorption of liquidity up to a realistic level would have been more in keeping with the exalted status of the State Bank. Actions that destablize markets, no matter how justified from a disciplinary point of view, should be taken with care. The concern should be avoidance of stress that undermines confidence, or neutralizes stabilizing measures taken earlier. The liquidity crisis may push up inter-bank rates, undoing the State Bank’s efforts at lowering lending rates.
The policy stance visibly lacks a concern for the health of the financial services sector, which is imperative for building investor confidence and economic stability. If this can’t be assured, nothing else will stay healthy. The drive for rapidly lowering interest rates, though commendable, appears to be rooted in the assumption that banks earn unrealistic spreads on loaning their deposits.The assumption is questionable in view of the recent lacklustre performance of Pakistani banks in terms of return on assets.
High operating costs, and loan loss provisions marred their performance. The recent SBP Annual Report admits that nearly 23 per cent loans attract loss provisioning. Neither loan losses nor operating costs can be rationalized quickly. Achieving this objective requires a qualitative change in bank management, more so in a country like Pakistan that suffers from decades long flawed banking practices. In the meantime, banks should be helped to improve their profits, and re-capitalize. Monetary management posture of the above type may not help this cause.
The drive to lower interest rates lacks an appreciation of connected market realities, principally inflation. A perception is therefore gaining ground that the rhetoric on benefits of lower interest rates has more to do with assisting the government in rapidly cutting its fiscal deficit and the industry its losses,both inefficient users of public savings, at the expense of the savers, much less with matching interest rate cuts with drops in inflation.
The State Bank must address the issue very credibly because interest rate management will have long-term implications for saving and investment sentiment. The activity must be objectives-driven, not dictated excessively by transitory market stresses. In its inter-action with business and industry, the State Bank has traditionally been over responsive to requests for diluting regulatory restrictions. Granting concessions to industry that allow sustaining inefficiency rather than containing it (implying a refusal to acknowledge the responsibility inherent in borrowing national savings) reflects shades of imprudence. No one doubts the State Bank’s sincerity of purpose— to help both the government and Pakistan’s beleaguered industry to cut is costs— but it must adopt a judicious route to achieving this objective.
The argument against a rapid drop in lending rates should be viewed in the background of the repayment record of a large part of Pakistan’s industry, which is reflected in the banking sector’s crippling loans losses. Does the industry need substantial support through lower interest rates alone? Or should the industry be advised to shed its high leverage to minimize the cost impact of borrowed capital? Or more needs to be done by way of cutting down state-controlled domestic input (energy, utilities) prices? Without changing the overall input cost scenario, lower interest rates will only encourage more borrowing to meet existing high input costs.
Corporate balance sheets are already in a bad shape. Ratio of short-term debt to liquid assets, and the ratio for debt servicing burden to profits, is fast becoming adverse. Interest payments are absorbing a record share of company profits. If companies continue to borrow, their financing gap will remain unusually wide indicating the need for a fall rather than a rise in investment. the present recession, which is unlikely to subside soon, makes the prospects worse. Debts that look manageable in good times can loom much larger in bad times.
Using the discount rate cut option in large doses (3 per cent in twelve weeks) effectively “forces’ a price on the market.it belies the claim of allowing prices to be determined by market forces, and negates the claim of making the economy market-based. Secondly, given the existing institutional framework wherein banks can change profit rates on over 40 per cent of their deposit liabilities (saving deposits) once in six months, and borrowers and lenders deal almost entirely on fixed rather than floating rates, it is difficult for financial institutions to transmit the impact of quick rate adjustments down the line without sustaining losses in the process. Thirdly, discount rate cuts soon lead to a reduction in bank earnings on statutory reserves thereby compounding their losses.
Admittedly, borrowers and lenders must get used to dynamic markets if they are to benefit from changing prices to survive in overly competitive world markets but it would be unrealistic to use the discount rate route to encourage them to deal on floating rates. It would be worthwhile to remember that, until recently, we did not have even the basic institutional arrangement - a yardstick interest rates system - for encouraging borrowing on floating rates.
A less disruptive route to meeting the same objective would have been to encourage both borrowers and lenders to deal on floating rates through appropriate forums to create a large lending/borrowing medium based on floating rates that is capable of absorbing rate changes without loss to either side. During the transition, rate cuts should have been moderate, and spaced realistically to allow smoother adjustments. Under the present institutional arrangements, rapid rate cuts create inequities between the interests of borrowers,lenders, and last but not the least, savers.
Cuts in profit rates on deposits (as a corollary of the discount rate cuts) will hurt savers since lower profit rates will result in higher negative real returns. Reason: in saver’s perception (which is not unrealistic), and quite rightly so, inflation is still well above 4 per cent. The latest estimates confirm that inflation rose by 6.71 per cent in the quarter ending December 2001. This perception matters, not the official claims about inflation. The fact that official inflation estimates have remained suspect for years is often lost sight of by policy-makers. On top of that, observers have expressed reservations about the revised basket of goods and services for determining the (official) level of inflation. Pakistan’s external debt is a reminder of our inability to generate resources domestically. True, there were many factors responsible for it,but high inflation and low returns on savings (especially on saving deposits in which the majority puts its savings) were the principal discouraging factor. Lower profit rates (resulting in negative real returns) will discourage savings even more.
In the present scenario, the effect of cutting the lending rates (and lowering profit rates on savings) is to transfer advantage from severs to the borrowers. Effectively, it allows both government and the industry to benefit unfairly without the savers being compensated (at least not in the foreseeable future given the unattended inefficiency in both government and industry) through lower inflation and increased purchasing power of their incomes. Being even indirectly instrumental in a transfer of advantage of this sort should be examined very carefully by the State Bank because it violates the sacred principle of maintaining equity between various sectors of the economy.
Lower profit rates could push savings out of bank deposits and government paper into speculative investments given the current market profile, which offers savers few other choices. Savings, it seems, are already on their way to Pakistan’s inadequately regulated stock markets. Ballooning of KSE index, without a significant rise in economic activity, indicates share buying at inflated prices and unrealistic hopes about corporate profits.
Being largely uninitiated to undertake such investments, savers may suffer from bad advice. This has happened all over the world, most recently on an unprecedented scale in the US where stock markets are much better regulated. Similar disasters are not lacking in Pakistan’s history. Remember the finance and investment company fiasco, and the losses small shareholders suffered in the 1990s at the hands of sharp stockbrokers? It is worth pondering whether such a diversion of savings will be good for the economy. Or should small savings be routed to industry through the caretaker system of banking? But it will require realistic profit rates on savings.
Having said all that, and in all fairness to the regulators, it must be said that there has been a discernible change in the quality of regulation. Change in the character of State Bank’s inter-action with market participants leading to speedy revision of regulatory procedures, and willing compliance thereof by the participants, is highly commendable.
The rapport is conducive for healthy regulation. Improved regulation has also hastened the rehabilitation of the country’s dwindling financial institutions, especially major banks and DFIs. Steps taken in this direction have borne fruit, though not without a cost in terms of their social fall. It is debatable whether this cost was worth bearing, or were less painful options available that were overlooked in the heat of the moment.
Privatization of banks and DFIs is essentially a government prerogative but the State Bank plays a pivotal role in these decisions. In this context, it is worth examining whether the effort to re-structure the big banks to prepare them for privatisation in their present form will deliver the desired results, or will it only fulfil IMF demands. There are many who believe that in spite of its sincere efforts, the State Bank will not get a fair deal in these privatizations. These unwieldy institutions, they argue, should be broken up into smaller units to make them appear more manageable, less risky, and therefore a good bargain at a fair premium.
It must not be overlooked that taxpayers, who paid for the losses of these institutions, have a stake in them and should be repaid in a visible form. That is unlikely if banks are privatised as they are. An evidence thereof is the lack of response from good investors. Offers received, so far, are from investors who may not do much good to Pakistan’s banking in the long-term.