EFFECTS OF FLACTUATING INTEREST RATES ON THE ECONOMY OF PAKISTAN

BILAL A. JUMANI - 6976SAAD T. AWAN - 7147

INTRODUCTION

•Pakistan started facing a deep economic crisis from the early months of 2008.

•When international food and energy prices

started to sky rocket, the balance of payments position went awry, resulting in heavy withdrawal of foreign exchange reserves and sharp depreciation of the rupee value.

•The government resorted to the orthodox

method of tightening monetary policy and hence the discount rate was raised to 13%.

•Even at this high rate the government was not able to significantly curb inflation and that coupled with sharply depleting foreign reserves.

•Government was left with no option but to reach out to the IMF.

•Among the conditions to bailout money from IMF, one was to immediately hike the discount rate by a further 200 base points to 15 %.

•Needless to say the increase in the key policy rate has had a severe effect on the domestic economy.

PROBLEM

•This graph clearly shows that by October 2008 our foreign exchange reserves had

reached a low point, government borrowing from the SBP was at an all time

high and year on year inflation had reached a staggering level.

•Apart from the mandatory requirement for obtaining the IMF bailout money, the reasons cited by the State Bank of Pakistan for hiking discount rates were three

▫Curb consumption to avoid second round of inflation

▫Improve real interest rates to encourage

FDI and strengthen the rupee

▫Curb credit expansion

•The results achieved so far have been unsatisfactory

▫Core inflation stays stubborn at more than 18%.

▫Consumption accounts for 80% of GDP

▫Food imports is 10% of the import, shown a 68% increase in the face of depreciating rupee, as food has a 40% weight in CPI the increased imports turns into inflation.

▫Even at a discount rate of 15%, the real interest rate remains significantly negative

▫Credit expansion for seven months FY-09 is 10.4%(17.8% annualized for FY-09); though lower than 28% in FY-08 is still higher than 16.4% in FY-07.

▫FDI in Pakistan has never been a function of interest rates.

▫Foreign investment is driven by the size and growth of the market, consumption pattern and stability. And unless stability comes back, monetary tightening cannot help.

IMPACT OF DISCOUNT RATE HIKE ON VARIOUS SECTORS OF

THE ECONOMY

TEXTILE SECTOR•Textile sector is the backbone of the

country’s export and mainstay of the economy.

•Out of the total annual export of $18 billion, Textile sector contributes $10 billion that is 60% of the total exports.

•Confronted with innumerable problems, including high cost of production, energy shortage, and high mark up.

• Due to variable mark up rates and slumping exports, textile industry (consuming a fifth of bank credit) has accumulated bad loans of over Rs320 billion.

• Beside the worsening energy shortages (raising production costs), global recession (reducing exports), and recent crash of the over- valued rupee, is the fruit of lending on floating rates to borrowers lacking financial literacy.

• Rising interest rates in Pakistan has put forward a major problem for this sector as it will increase the number of non performing loans and it will increase the cost of production causing exporters losing competitiveness in international market.

INSURANCE SECTOR•Pakistan’s insurance sector has

experienced accelerated growth and robust profitability, augmenting its overall risk absorption capacity in recent years.

•Now faces major challenges arising from various broad socio-economic risks, including ongoing stock market turbulence, rising trend in the interest rates, widening fiscal and trade imbalances and worsening security conditions.

•The rising interest rate scenario has already dampened auto financing, besides impairing business initiatives hitherto demonstrated by large-scale manufacturing and SMEs.

•PACRA, therefore, sees pressure mounting on the insurance sector, which may impact its growth prospects, profitability and liquidity, undermining its overall financial strength.

BANKING SECTOR•Most of the commercial banks have

announced their full year financial results for the period ended Dec 31st 2009. Two main observations deserve a specific mention:

▫Investment in government securities: In a high interest rate environment, the banks normally prefer to invest in the safer government securities and papers like treasury bills even if they fetch lower interest earnings

▫The “crowding out” of the private sector means that the economic growth will suffer, resulting in industrial closures, bank defaults and massive job losses.

▫Rise in Non performing loans.

• The banking spread, difference between lending and deposit rates, reached a record level of 7.78 per cent in January. It is considered to be negative for depositors.

• In times of such high inflation it is difficult to say that depositors will get real positive return.

•Banks are lending in the range of 18 to 27 per cent. The highest cost is paid by small borrowers as consumer loans are charged with highest interest rates.

AUTO FINANCING•Use of high interest rates as a tool to curb

inflation is drying up private sector credit demand; this is a worrisome situation for many banks, as at the moment our economy needs a boost through credit demand which can trigger GDP.

▫First & most important reason is hike in interest rates.

STOCK MARKET

•The escalated interest rates had increased borrowing costs and severely dented growth in the economy.

•Major industries like manufacturing and services sectors were highly leveraged and this higher interest rate scenario had blanked their expected future growth.

•The financial performance of all the companies and sectors deteriorated and hence the investment markets, especially the stock market, dived down to their lowest.

•Due to manufacturing and service sector decline, the foreign direct investment FDI in Pakistan, which was growing at a robust 5 year cumulative aggregate growth rate (CAGR) of 52.65% and the total foreign investments at 42.46% have dived to their lowest.

•Portfolio investment in stocks have been most volatile, which stood at US $ 311 million during FY-04, marked high of US $ 3,288.30 million during FY-07, but declined to US $ 40.16 million for the FY-08.

• In short, the stock market has been hit three folds due to increasing interest rates:

▫One is CFS financing, which was the main elevator of stocks.

▫Secondly, industrial decline resulted in lower forecasting of future stock prices.

▫Declining index, people started saving and investing in commodities which created a liquidity crunch in the financial market

•The escalated interest rates finally made the stock market to discount its values by more than 50% and touched 4000 points from above 15600 level’s peak.

RECOMMENDATIONS

•After months of tight monetary policy now there is a cut in discount rates to 12.5% but it should further brought down.

•If a high discount rate has resulted in lower growth and prolonged high inflation then a cut in discount rate could mean higher growth and lower inflation.

•Following is our analysis of what the possible effects of a sharp cut in discount rate could be:

▫Potential Consequences

Many analysts warn that a sharp cut in discount rate could put pressure on the exchange rate, lead to currency depreciation and foreign exchange drain, wiping out all the macroeconomic gains made so far to stabilize the economy in the recent months.

▫Potential benefits

For an emerging economy like ours, nothing is more important than growth. And, a cut in discount rate may well achieve that due to the simple reason that growth and discount rate are two negatively correlated terms, at least as far as our economy is concerned.

As growth bounces back and businesses become more profitable, foreign investors would once again bring their money here resulting in foreign exchange inflow and stronger rupee which in turn will result in lower imported inflation

The stock market will revive, creating greater availability of capital and an option for businesses to substitute debt for equity. This would result in greater profitability and make the stock market even more attractive to the investor. The end result would be a vibrant economy, stronger rupee and thus a lower and economically viable inflation rate.

CONCLUSION•The above comparison shows that the case

for cutting discount rate is certainly very strong.

▫The central bank should reduce its discount rate gradually to ensure exchange rate stability.

▫Inflation in our country remains sticky not because of aggregate demand pressures but due to lack of administrative control over the prices of commodities, therefore the government must monitor prices in the market to control inflation

▫In economic crises the staggering amounts of nonperforming loans the commercial banks are charging very high interests, therefore even after the cut in discount rate the central bank should ensure that the commercial banks are advancing loans to foster economic growth.

▫The SBP must monitor closely the lending practices of the commercial banks.

▫The SBP must force the commercial banks to reduce their banking spread so that the benefit of lowering discount rate also reaches the general public