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Needed: further rate cut and slash in PIB coupon

May 27, 2015

By: ASAD RIZVI (KARACHI)   Published on May 27, 2015
State Bank of Pakistan in its Saturday’s monetary policy statement announced introduction of “Target Rate”, as its new policy rate, which is 50 basis points below the ceiling rate, aiming to keep overnight money market rates (repo rate) close to the target rate.

SBP has surely sensed the urgency of better liquidity management in coming months due to growing size of Pakistan’s deficit-ridden economy and decided to act quickly. Government bond maturities in calendar year 2016 are roughly around Rs 1.5 trillion. It is the responsibility of a central bank to regulate liquidity or money supply in the banking system, which can only be made possible through credible data. Acquiring of appropriate and timely financial data for huge amount size is always a daunting task due to time lag effect.

In practice for its effective use, central bank regularly conducts open market operations (OMOs), which is sale, and purchase of government securities; it’s an important monetary tool that helps in meeting its short-term objective that involves money and pricing in shape of interest.

Here, it is important to understand the application mechanism that interest is considered as price or cost of money, which is a commodity. Supply and demand is the key factor to determine both. Hence to make its effective use and to ease liquidity conditions, lowering of target rate would be SBP’s preferred choice. Similarly in tighter market conditions, liquidity can be made available through purchase of government securities. SBP’s decision will be based on its policy stance.

Interbank market has so far shown good understanding about “Target Rate” set at 6.5 percent by reading the message correctly. In the last 2 days, KIBOR rate was stable, as offered rate of overnight rate were 6.81 percent, 3-months was 6.77 percent, 6 months 6.79 pct and 12-months 7.12 percent respectively. Similarly, after a 100 basis point rate cut, yields in government paper made slight gains ranging between 10-20 bps, as prior to rate cut, yield made a minor upward adjustment.

There is mixed debate about the pros and cons of discount rate cut. Since November 18, 2013 SBP has slashed Discount Rate by 300 basis points to 7 percent. This mean based on total current holding of Rs 6.791 trillion government securities’ debt burden will be reduced by Rs 203 billion on annual basis. In addition to Rs 203 billion interest payment that government is expected to save due to a 300 basis point slash in discount rate based on current PIB holding of Rs 4.046 trillion. On an average, a 2.25 percent cut in coupon government will save another amount of Rs 91 billion annually.

However, so far rate cut could not give respite to the ailing economy, as reading of SBP economic data shows credit to private sector grew by mere Rs 162 billion. It is estimated that 25 percent of the fall in private sector growth is caused by easing of commodity prices.

Whereas, banks are extremely comfortable to invest in nearly zero-risk government paper, which is still too attractive because PIB coupons of 3-10 years ranging between 8.75 and 9.75 are very appealing. Banks are not too much concerned with the current pace of rate cut, which in my view is still very tempting.

At 7 percent discount rate of 6.5 percent “Target Rate”, I do not see any reason for economic stimulation unless discount rate is slashed by another 100 basis points and coupon rate slashed by another 250 basis points. Hence overall benefit in shape of debt reduction in interest payment after a slash of 400 basis points rate cut would be RS 263 billion and 4.75 coupon rate cut would save Rs 192 billion.

While, there is another Rs 65 billion debt saving against Unfunded Debt of Rs 2.645 trillion under the head of Government Domestic Debt and Liabilities, which amount to total annual saving of Rs 520 billion. If rates and coupon are further slashed, then credit for such a huge amount of savings will go to government’s favour. Furthermore, it is worth nothing that the current break-up of banks total Statuary Liquidity Requirement (SLR is PIB 15 percent, T-bill 4 percent and cash 5 percent), which means PIB investments by banks in excess of 15 percent, will not be part of SLR. But banks can invest in T-bills up to any amount that can be part of their reserve requirements.

Therefore, for economic stimulation purpose, ideally investment in government securities should be capped with maximum investment allowed up to PIB 21 percent. Any percentage of excess investment should be taxed and simultaneously certain percentage of excess investment in government paper that can be worked out should be made conditional lending to private sector.

Or else with present strategy and current level of discount rate and return on investments, it is so attractive that banks will not respond to SBP’s rate cut and its growth effort will go to waste. The biggest risk is that Chinese investment based at current policy rate and after including the risk cost is still too costly from the investor’s perspective that could backfire if SBP and Ministry of Finance (MoF) remain too complacent.

Copyright Business Recorder, 2015

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