How much policy rate needs to be reduced in Pakistan?
State Bank will try to cut rate slowly to avoid capital outflow
Representational image. PHOTO: REUTERS
LAHORE:
There is a growing pressure on the government to reduce the policy rate.
Time and again, members of the business community have met Prime Minister Imran Khan and asked for a reduction in the policy rate. A former minister has filed a petition in the Supreme Court of Pakistan where the high policy rate has been challenged.
The State Bank of Pakistan (SBP) has been maintaining a high policy rate to rein in aggregate demand. The SBP’s target is core inflation, which is non-food and non-energy.
Statistics of core inflation are in the range of 7-8% in the last one year. Keeping in view the stability of core inflation, one can easily build a case for reduction in the policy rate.
The current policy rate of 13.25% is very high considering the stable core inflation. The market had anticipated a reduction in the policy rate in the last two monetary policy announcements. Even the business community had expected a decline in the policy rate.
However, the wishes of the market and business community have not come true.
There are pros and cons associated with the high policy rate. The high policy rate is good for the financial sector. In addition to this, it helps in attracting ‘hot money’.
On the other hand, the high policy rate is quite bad for businesses. Specifically, the businesses, which have expanded their operations, face difficulties in meeting their debt servicing costs. The high policy rate also makes working capital difficulties for them, even for the start-ups, which intend to grow but face problems.
In case of Pakistan, the situation gets worse since debt servicing cost of the government increases a great deal. After defence needs and debt servicing, the cushion of the government goes down significantly as it hardly meets its current expenditure requirements. Therefore, the development expenditure needs to be cut down.
Now, the question is how much policy rate needs to be reduced. The SBP will try to reduce the policy rate slowly so that capital outflow could not take place.
This gradual reduction will not bode well for the real economy. However, the policy rate may be brought around 11% in order to provide relief to the real economy.
The headline inflation touched 14.6% in January 2020 where the food component had been contributing heavily. Administrative prices have been playing a major role in jacking up the prices.
Prices of electricity have been revised upwards a number of times. Similarly, a palpable increase has been witnessed in the gas tariff. When electricity and gas tariffs have been increased simultaneously, it will increase the cost of food basket a great deal. As inputs get expensive, the producers take time to pass the impact on to end-consumers. However, they have that calculation in mind and pass on the price increase when they foresee high demand.
When they anticipate high demand, they revise up the prices. Under these circumstances, clampdown by the government on the hoarders does not improve the situation. It even further aggravates the situation.
In short, the government can control food and energy inflation either by maintaining support prices of essential food items or by maintaining the electricity and gas tariffs or even revising these tariffs downwards.
On the other hand, the SBP focuses on the core inflation to gauge the aggregate demand pressure in the economy. In addition, it has to manage the foreign exchange reserves.
Under these circumstances, the high policy rate will further tighten the liquidity of businesses. Let us see how technocrats cope with this mounting pressure.
The writer is the Assistant Professor of Economics at SDSB, Lahore University of Management Sciences
Published in The Express Tribune, February 24th, 2020.
There is a growing pressure on the government to reduce the policy rate.
Time and again, members of the business community have met Prime Minister Imran Khan and asked for a reduction in the policy rate. A former minister has filed a petition in the Supreme Court of Pakistan where the high policy rate has been challenged.
The State Bank of Pakistan (SBP) has been maintaining a high policy rate to rein in aggregate demand. The SBP’s target is core inflation, which is non-food and non-energy.
Statistics of core inflation are in the range of 7-8% in the last one year. Keeping in view the stability of core inflation, one can easily build a case for reduction in the policy rate.
The current policy rate of 13.25% is very high considering the stable core inflation. The market had anticipated a reduction in the policy rate in the last two monetary policy announcements. Even the business community had expected a decline in the policy rate.
However, the wishes of the market and business community have not come true.
There are pros and cons associated with the high policy rate. The high policy rate is good for the financial sector. In addition to this, it helps in attracting ‘hot money’.
On the other hand, the high policy rate is quite bad for businesses. Specifically, the businesses, which have expanded their operations, face difficulties in meeting their debt servicing costs. The high policy rate also makes working capital difficulties for them, even for the start-ups, which intend to grow but face problems.
In case of Pakistan, the situation gets worse since debt servicing cost of the government increases a great deal. After defence needs and debt servicing, the cushion of the government goes down significantly as it hardly meets its current expenditure requirements. Therefore, the development expenditure needs to be cut down.
Now, the question is how much policy rate needs to be reduced. The SBP will try to reduce the policy rate slowly so that capital outflow could not take place.
This gradual reduction will not bode well for the real economy. However, the policy rate may be brought around 11% in order to provide relief to the real economy.
The headline inflation touched 14.6% in January 2020 where the food component had been contributing heavily. Administrative prices have been playing a major role in jacking up the prices.
Prices of electricity have been revised upwards a number of times. Similarly, a palpable increase has been witnessed in the gas tariff. When electricity and gas tariffs have been increased simultaneously, it will increase the cost of food basket a great deal. As inputs get expensive, the producers take time to pass the impact on to end-consumers. However, they have that calculation in mind and pass on the price increase when they foresee high demand.
When they anticipate high demand, they revise up the prices. Under these circumstances, clampdown by the government on the hoarders does not improve the situation. It even further aggravates the situation.
In short, the government can control food and energy inflation either by maintaining support prices of essential food items or by maintaining the electricity and gas tariffs or even revising these tariffs downwards.
On the other hand, the SBP focuses on the core inflation to gauge the aggregate demand pressure in the economy. In addition, it has to manage the foreign exchange reserves.
Under these circumstances, the high policy rate will further tighten the liquidity of businesses. Let us see how technocrats cope with this mounting pressure.
The writer is the Assistant Professor of Economics at SDSB, Lahore University of Management Sciences
Published in The Express Tribune, February 24th, 2020.