One of the basic elements of the New Economic Order is to allow market forces to allocate resources through freely determined prices. Accordingly, the financial sector reform in Pakistan, which is financed by the World Bank, has sought to deregulate interest rate and introduce market-determined rates since early nineties.
The process gathered momentum under the PRGF of the IMF, which stipulated that the SBP would auction public debt and use the rate thus worked out as a benchmark for other interest rates.
Of particular interest in this regard was to be the return on the NSS. This was believed to be very high and was to be gradually brought in line with the rate for Pakistan investment bonds (PIBs) determined through auction. This rate has seen a downward trend. During 2001-2, the rates for 3-year bond fell from 12.5 per cent to 8.8 percent while that on 5-year bond was down from 13.0 percent to 9.8 per cent.
Accordingly, the return on the NSS has been gradually reduced. For DSC the 10-year compound rate has been reduced from 18.04 percent in 1998 to 11.61 per cent with effect from July 1, 2002 and for SSC from 16.0 per cent for the first 5 half-years and 18.0 percent for the 6th half-year to 10.3 per cent and 11.3 per cent respectively. In view of the crucial importance of the interest rate on the PIBs, as a determinant of the NSS, the question is: How far this rate is really market-determined?
A genuine market rate will emerge only if the supply and demand for investable funds is not in any way influenced by any extraneous factor. As to the supply of investable funds, this should be based on genuine public saving.
The traditional and orthodox view of the central banking has been that it should serve as the lender of last resort to help financial institutions to get over their temporary liquidity difficulties. In developing economies, where the institutional framework is either non-existent or too rudimentary to be able to play its role in mobilizing savings for financing economic development, central banks at times take upon themselves to create or nurture the system.
This development role of the central bank is supposed to be temporary, because if continued for too long, it can come in conflict with its primary regulatory functions. In Pakistan, to begin with, whatever few commercial banks were there they were closed with the exodus of non-Muslims who financed and manned them.Therefore, there was no financial sector worth the name and had to be started from scratch. Even the central bank had to be established. This perfectly justified an active developmental role of the central bank. It was a daunting task to sponsor, finance and even man the whole array of new financial institutions. Financing of these institutions by the central bank in the initial stages was necessary due to the fact that there was very little private capital in the country and that too was quite shy.
The central bank was expected to withdraw as soon these institutions found their feet and could stand on their own. However, for a variety of reasons, the central bank continued to finance them on a massive scale so much so that some of them are totally dependent on it, so far as their local resources are concerned. Even commercial banks serve as a conduit for the central bank for disbursing, for a hefty commission, concessional credit like export finance. On top of this, the central bank has been deeply involved in financing budget deficit. As a result, most of money creation in Pakistan has been due to the central bank, accounting for as much as two-third of the total money supply in recent years. This stood at 65.0 percent in 2001.
The restrictions imposed by the IMF, as one of the basic conditionalities for the PRGF, have made the central bank reduce its contribution to money supply to one-third (38.7 per cent) of the total during FY 02. With such a massive injection of money by the central bank, at one stage close to total investment in the NSS, the market rate of interest on the PIBs is nothing but a myth. What is there is just a reflection of interest rate policy of the central bank.
The central bank’s pre-occupation with its assumed developmental role has been at the expense of its regulatory function. This has far reaching implications for the economy in general and monetary management in particular. It is agreed and also admitted by the central bank that weak regulation has been largely responsible for the highly infected asset portfolio of the financial institutions.
It is very easy and convenient for the financial institutions to obtain funds from the central bank lump sum than to deal with numerous uncouth illiterate depositors and undertake the required book keeping. They, therefore, do not care for one of their basic functions of deposit mobilization.
What is perhaps more important is its impact on the return available to the saver. The very fact that interest rate is depressed by artificial means makes the system tilt in favour of the users of investable funds, most of whom are quite affluent in their own right, and is at the expense of their suppliers who in Pakistan are mostly the small saver.
This anti-saving policy stance ignores the currently deplorable rate of domestic saving, which is the fundamental cause of increasing reliance on the already unmanageable external debt and constraints investment to a very low rate grossly inadequate to stimulate economic growth in the country.