Will 150 basis points cut spur growth?

Tuesday October, 11 2011

GMT 5:44    PAK 10:44 am

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 based growth, 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.

Cut policy rate by 150 to 200 basis points

Friday, October 07, 2011

Last week, a report carried by a section of press quoted Defence Minister Chaudhry Ahmed Mukhtar as saying that the government is likely to bring down interest rate by two to three percent in the near future and that he has discussed this matter with President Zardari who, according to him, was in favour of a rate cut.

Although, this subject does not pertain to the Ministry that he heads, but being a successful businessman Chaudhry Mukhtar definitely understands the urgency of drastic rate cut, as higher discount rate is one of the major damaging factors for economy.

I strongly support and endorse the view, as it has now become evident that high discount rate is no more sustainable. It has been causing a great harm to economy. There is a global war against high interest rates and despite higher inflation all the major debt ridden global economies have either slashed or are in the process of reducing high interest rates to protect their economies.

The truth is that the global norms have changed, as major economies do not go by the book anymore. For the last few years printing of notes in tons and real interest rates in the negative is no more considered a sin and is practiced all over Europe and the USA to support their economies. In the UK, despite inflation breaching its 2 percent target limits, which is currently hovering around 4.5 percent, the Bank of England has kept its interest rate at 0.5 percent due to poor health of Britain's economy. In the US, despite CPI at 3.8 percent FED has opted for a loose monetary policy by keeping its rate at 0.25 percent. Similarly, Euro zone's inflation, rate already at 2.5 percent, is expected to rise further. ECB kept its rate unchanged at 1.5 percent.

More importantly, to save Europe from a financial collapse, Germany, which is considered one of the most modern democratic countries, went to such an extreme extent that its parliament voted in favour of bailout expansion despite opinion polls were suggesting that 70 pct of the population does not favour bailout expansion.

The State Bank of Pakistan will be announcing its monetary policy on Saturday, October 08. Now it is SBP's turn to shoulder the responsibility. The Central Bank should have anticipated the quantum of damage that its continued tighter stance is inflicting on the nation. Pakistan's economy has already paid a very high price at the expense of growth to contain inflation by keeping its discount rate in double digits, which is in its fourth consecutive year.

The worrisome factor is that despite maintaining tight monetary policy for the last five years, inflation hovered between 13 percent and 15 percent. During this period, the economy could not produce new jobs to keep pace with the population growth, thus widening the gap. Instead, the market witnessed death of economic activity, which is ultimately leading to cause social unrest and tensions in the country. It is, however, understandable when SBP through its monetary policy blames a lack of fiscal support as a major cause of high inflation because without fiscal support monetary management is less effective and makes no sense.

But the point to ponder is that if food, oil and energy prices in Pakistan are compared with the prices in international market, they are either low or at par, whereas inflation abroad is too low. So why are inflation numbers constantly so high in Pakistan? Is this because the basket of inflation not balanced? This could be a factor, but resistance to documentation of economy is the real culprit. If we look at inflation graph of under-developed economies, most undocumented economies suffer from high inflation.

However, State Bank of Pakistan has to realise that it is the Central Bank's responsibility to stimulate economy. It has to strike a delicate balance. The list of issues has attained to a dangerous level, which needs to be corrected without any loss of time. Tightening for the sake of fiscal discipline makes no sense.

SBP's top priority should be to provide such a healthy environment that helps businesses in the country to flourish. It should ensure ample of liquidity for new business opening, as banks are only keen to fund running business. Due to higher interest rate policy, in the last four years private sector growth has been choked, causing a lot of damage to the business sector resulting in an alarming surge in NPLs. A large part of the money has been diverted to the government sector.

Flaws in SBP's policy stance are clearly visible. Instead of supporting growth in the private sector, it is injecting liquidity by using two of its monetary tools to provide liquidity to the banks to encourage banks and financial institutions to purchase government securities. For the last two months, the market has witnessed a huge liquidity injection through Central Bank's open market operations (OMOs) and so far SBP has injected over Rs 300 billion of liquidity to meet the government securities target. The second tool that the Central Bank has been employing for the last 5 or 6 months clearly negates its tighter monetary policy stance. It has created such an environment that in the last six months, forward premiums fell sharply to 260 paisa, which means that at this rate if a bank carries out a Rupee/Dollar Sell/Buy swap the Rupee cost would be 7 pct. Then banks were investing in T/bills at 13.25% yield. Presently, 6-month swap is trading at 330 paisa, which makes Rupee available at 8.5 percent. Exporters are also blaming a sharp drop in forward premium as one of main factors behind the recent drop in the value of Pak Rupee against Dollar, which forced them to hold their foreign currency in hope for recovery, putting pressure on Rupee. However, Rupee's weakness was more due to widening gap between interbank market rate and Kerb market rate.

In August 2009, SBP introduced Interest Rate Corridor to reduce short-term interest rate volatility to bring more transparency in the implementation of its monetary policy. 3-day Repo facility was renamed as Reverse Repo Facility, which is known as "Ceiling" and Repo Facility became "Floor", which means that based on current discount SBP will lend funds to banks at a ceiling rate of 13.5 percent and will absorb excess funds from the market at 10.5 percent ie, floor rate. The gap between floor and ceiling is 3 percent.

Another major factor that is causing difficulty in containing inflation is the disparity caused due to a 5 percent floor on savings rate, which makes no greater sense as banks can pay maximum of 5 percent on savings account; banks can invest in treasury bills at around 13 percent and have another window facility to place excessive funds at the corridor floor rate on a daily basis.

SBP in its monetary policy announcement should adjust the savings floor rate at par with the corridor floor rate at which SBP absorbs funds from the interbank market or should make a realistic adjustment between the savings floor rate and corridor floor rate. This rate disparity is the hidden culprit behind rising inflation, which goes unchecked. It is also one of the major causes of high currency in circulation that has surged to 1.570 trillion, which is not manageable. Low saving floor is also responsible for a low national savings ratio, which also inflates the incidence of currency in circulation.

My greatest concern is the bank exposure to government securities. The latest talk on circular debt settlement, which is almost a done deal, will be added to banks investment portfolio. It is extremely alarming that after the settlement of Rs 400 billion circular debt trough T/bills and PIBs, a new dimension will be created in the banking system. Presently deposit of schedule banks is Rs 5.9 trillion and advances is Rs 3.8 trillion. Circular debt adjustment entry will reduce bank advances, which means schedule banks advances will drop to Rs 3.4 trillion, but investment in government securities will surge to Rs 3.5 trillion.

It means that for the first time in the history of banks investment in government will exceed banks' advances portfolios. Current holdings as of now are T/bills 2.315 trillion; PIB Rs 550 billion; and Sukuk Rs 185 billion. With an unfunded debt portfolio of 1.52 trillion, are we not falling into a debt trap? It will also have negative repercussions as it is most likely that rating agencies will chop banks rating due to excessive investments in government securities.

Furthermore, there is every reason to believe that Pakistan will not get foreign support. IMF is done with USD 7.3 billion loan to Pakistan. Kerry/Lugar bill to give Pakistan USD 1.5 billion annually for 5-years now sounds more like a gimmick than a possibility of any kind, as the country did not get any money after the release of its initial tranche. Japan has been kind enough to provide goods worth USD 10 million after last month floods in Pakistan.

Keeping in view the global trend and country's economic condition and inflation numbers dropping to 10.56 percent, this is an ideal opportunity to slash the rate by 150 to 200 basis points on October 8 and slash another 100 to 150 basis point in the next MPC.

There is a wrong perception that a sharp cut in discount rate will have a negative impact on Rupee. It will have no adverse impact on country's trade if we take into account the past two major moves, in which Rupee appreciated (2002-03) and Rupee got the beating (2008-09). This is because Pakistan's large chunk of import is oil based, which depends on international oil price movement and prices are adjusted by the local market.

Similarly, textile is the largest export component and past trend suggest that it's mostly driven by the domestic market sentiment. Exchange rate mostly reacts to shifting in balance of payment position (Negative or Positive). Or moves are witnessed when the parallel market, ie, Kerb market behaves disorderly. Therefore, there is hardly any time left for the SBP; this is a wake-up call. A 50 basis point cut will be too little and too late. Zardari is thinking in the right direction.