SBP’s interest rate policy

The State Bank of Pakistan (SBP) is coming out from the shadows of its high interest rate policy to respond to the shock to the economy caused by Covid-19. The Monetary Policy Committee (MPC) of the central bank announced a 100 basis points (bps) cut in the policy interest rate, from 8 per cent to 7 per cent, on 25 June. This was the fifth reduction in the rate since mid-March, with a total cut of 6.25 per cent over this period.

The MPC view is that this reduction in the policy rate will work as a cushion by easing the borrowing costs and debt service burden on the private sector and will support employment and growth in the economy. It also expects that inflation will fall further than the earlier announced range of 7 to 9 per cent in the fiscal year 2020-21.

The direction of the policy appears right. However, a key question is whether these cuts by the SBP are enough to address the severity of the economic shock from the reigning coronavirus pandemic. Let’s see if they can sufficiently reduce the cost of borrowing and encourage investment to generate employment and growth.

There is no simple and certain answer to this, especially not during the middle of the coronavirus pandemic when the shocks are still unfolding. However, it may be suggested — with a degree of certainty — that the recent reductions in the policy rate were long overdue and are needed at least to minimise the damage to the economy of a high interest rate.

The baseline policy rate, 13.25 per cent, in force from July 2019 to 16 March 2020, was one of the highest rates in the country’s history. It had been increased very rapidly over a period of one year, from less than 7 per cent before July 2018. Moreover, this rate was much higher than that in many emerging economies in the world, including those in South Asia. It was twice as high as India’s 6.5 per cent and Bangladesh’s 6 per cent in the same period. Even before the shocks of the coronavirus, this had a severe effect on private investment, unemployment and exports.

The Economic Survey of Pakistan, 2019-20, shows that overall credit to the private sector declined by nearly half, from Rs581 billion in 2019 to Rs305 billion, and exports also declined considerably on a year-on-year basis. The growth in industrial and service sectors, two major sources of employment and economic growth, declined to -2.64 per cent and -0.59 per cent, respectively.

The cumulative cuts in the policy rate of 6.25 per cent since March should be seen in the wider context of the cost of the higher interest rate. The new policy rate of 7 per cent in Pakistan is still higher than India’s 4 per cent and Bangladesh’s 5.75 per cent.

To reduce the cost of borrowings to small firms and households, the SBP should consider introducing a ceiling of 10 per cent on the commercial banks, for end-loan users. Bangladesh has introduced a ceiling 9 per cent.

A major risk of this policy might be a surge in inflation. In the present pandemic crisis, however, households are struggling to make ends meet rather than spending and generating excess demand. Therefore, the risk of demand-induced inflation appears extremely low. Another potential risk of inflation may come from the disruption of supply chains which may cause a hike in prices of essential food and non-food items, like wheat and petroleum products.

The recent decision by the government to increase the petroleum prices by over 25 per cent — one of the highest increases in a single day in decades, after the cut in policy rate — has increased this risk. This has also put pressure on private sector business and the cost of living, particularly for the poor.

The SBP and the government require more co-ordination to provide relief to the private sector to encourage investment and generate employment and to also protect households from inflationary shocks in the economy.

Published in The Express Tribune, July 13^th, 2020.

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