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Will 150 basis points cut spur growth?

February 13, 2014

Business Recorder Logo

October 11, 2011

Why is that a 150 bps cut will not stimulate economy? This is true that a discount rate cut is generally helpful for the economy, but in our case, however, it doesn’t. Time will prove that despite slashing discount rate to 12 percent, Pakistan’s economy will still not get the much-needed boost.

The real beneficiary of this cut will be the borrowers of running businesses that have been paying an exorbitantly high rate on their bank borrowings or government will get some relief due to cost reduction in its debt servicing. I do not see any increased business activity for two broad reasons.First, 12 percent is too attractive and too safe a rate for the banks to invest their cheap deposits in government securities, while the second factor is that if we look at the corporate sector lending graph of last 5 years, it is on a constant decline as there has been no new major corporate lending. Five years ago, scheduled banks’ Advance to Deposit ratio attained a peak of 77 percent, which had dropped to 62 percent by June 2011 and after the adjustment of Rs 400 billion of inter-agency circular debt of energy sector Advance/Deposit ratio will take a further dip of 58 percent.In the last five years, Pakistan suffered one of the highest rates of inflation. If we go by the books, high inflation is always considered useful from perspective of growth. But this theory proved to be absolutely wrong in our case. The declining trend of advance/deposit ratio for the last five years is parallel in line with a declining trend of country’s GDP growth, which clearly depicts the true picture of our economy, further confirming the fact that high inflation rate was harmful and it was a meager effort on the part of SBP to boost growth and create jobs.However, if we look at the bank’s investment trend in government securities, which has surged sharply in the last couple of years, it clearly tells the true story and exposes the central bank’s reluctance to support growth. It would not be wrong to say that for the last one year and a half, State Bank of Pakistan’s monetary policy is a mix, as it was maintaining tighter policy stance while simultaneously managing liquidity through unannounced quantitative easing by injecting liquidity to encourage banks to invest in government securities.It is unfortunate the SBP did not inject liquidity to support growth. The sheer purpose of rupee injection was to encourage investment in government securities to reduce government borrowing. It is extremely important to strike a balance between revenue collections and spending, which is the only way out to survive.Since there is no real money available in the banking system and the deposit growth is largely the result of interest income on accrual basedgrowth, therefore, the current discount rate is still too high to discourage new businesses and still too attractive for the banks to invest in government paper. It is more likely that by the end of FY 12, advance to deposit ratio will further fall to below 55 percent instead of inching up from the current level.Hence, if SBP really wants to see growth in private sector and create employment, it has to slash its discount rate by another 200-300 basis points and take advantage to align borrowing cost. SBP is also required to correct the rate imbalance that it has created by maintaining so many different rates, which is doing no good to the economy.Impact of cut in discount rate The impact of the rate cut saw a positive response from the Karachi Stock Exchange, both in terms of trend and volume. But this bullish tone may not last for a long period of time unless new liquidity is made available to the stock market.Meanwhile, six-month KIBOR opened at 11.96 percent. In the interbank money market, banks still have appetite to purchase T-bills and PIBs in hope that the SBP would continue its unannounced quantitative easing strategy and inject more funds to meet the increased demand for government paper. Banks were aggressively bidding one-year T-bills around 11.88 percent yield and PIBs around 12.04 percent yield, which clearly indicates that the market is expecting a further discount rate cut. Moreover, the demand for government securities will not subside.The much-awaited unsettled pending issue of Rs 400 billion of inter-agency circular debt of energy sector has been lingering on since May,2011. In the past, on two occasions banks were notified of circular debt deal settlement in writing, but due to some unknown reasons the deal could not conclude. No bank was informed about its fate. This clearly indicates a weak co-ordination between the SBP and MoF, as the deal structure is yet to be finalised since there are quite a few technical glitches. A direct deal with banks also questions the credibility of the system, because there are foreign investments in the government securities and direct negotiation with banks would amount to interference in price mechanism.In simple terms, Ministry of Finance should have asked SBP to finalise and conclude the transaction. SBP would have been a safe negotiator for government and as well as for the banks. Delay is also a blessing in disguise for the government because it is expected that the settlement of transaction will be based on average of current and past yields, which is also in the national interest. This circular debt deal has its own pros and cons because on one side it will provide space in the balance sheet of the customer, whereas PIBs held by banks will worsen their capital adequacy ratio.Interestingly, PIBs yield after hitting the high of 14.45 percent in February/March started sliding on huge demand, which came mainly from the government of Sindh due to its bond maturity. It is estimated that so far it has purchased 10-year government paper of up to Rs 45-50 billion to hedge its employees’ gratuity and provident fund. Insurance companies are the other major buyers of PIBs. This clearly indicates that there is a plenty of appetite for more buying as this buying was not projected in the earlier PIBs targets. Therefore, until next monetary policy announcement yield of T-bills and PIBs could decline by another 50-100 basis points. The trend of buying 12-month T-bills is likely to continue. In the coming PIB auction due on Wednesday, October 12 corporate interest would dominate the banks.I do not expect any major move in the interbank foreign exchange market. In the coming days, however, I see rupee gaining strength against USD, as it is important to understand that the normal theoretical linkages between interest rate and exchange rate do not hold true for Pakistan as it is not convertible on capital account nor is the economy exposed to substantial short-term foreign investments, which could have had impact of major interest rate moving either way.

Copyright Business Recorder, 2011

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