Will unwarranted rate increase solve problems?

Beyond certain threshold, marginal utility of interest rates decreases in controlling imports

AAH Soomro September 11, 2023


The State Bank of Pakistan (SBP) is mulling over monetary policy decision this week. The economic contraction is so severe that this entire fiscal year will be marred with economic, social and political chaos.

Entire population – educated or not – is either discussing dollar rate or inflationary trends in fuel and food prices. Granted that central bank’s primary job constitutes reining in inflation, but will the expected interest rate hike solve the problems or add to them?

Firstly, inflation in Pakistan is not led by excessive demand (demand-pull). Purchasing power is negligible and neither is economy overheating to create shortages or abnormal profits. Domestic inflationary wave is driven by currency depreciation, utility price hikes, global food prices and administrative failures (cost-push).

Secondly, inflation is not an outcome of excessive money supply in the country. Surely, exorbitant cash in circulation is not returning back to formal channels with an interest rate hike.

SBP’s concessionary financing schemes have been unduly overly criticised but they haven’t added a material “inflationary wave”. Country is already running a super-tight primary deficit with limited discretionary funds for development.

Also read SBP maintains record high policy rate

Thirdly, recent data suggests an alarming trend that in July the government paid Rs537 billion in interest payments, which is as high as total FBR’s tax revenues of Rs537 billion.

Though part of the debt comes back to the exchequer in the form of higher SBP profit but the debt remains heavily concentrated in domestic borrowing and a 1% increase in policy rate can further increase interest payments by Rs350-400 billion per year. You and I will repay that with higher taxation.

Fourthly, in comparable countries, interest rates are not that astronomical vis-a-vis inflation. With 80% inflation, Turkey has 25% interest rate. With 36% inflation, Egypt has 20% interest rate. And with a default history, Sri Lanka has 11% interest rate with an enviable 5% inflation.

Obviously, it should be 12-month forward interest rate deciding the fate of real (inflation-adjusted) interest rates but central banks in emerging markets have been poorer forecaster of currency depreciation/ inflation and have compromised their credibility with such overly optimistic or pessimistic real interest rates.

Lastly, most important is the perception that interest rates can arrest dollar outflows. In a hyper inflationary scenario, such as that of Argentina or Turkey, sharp hikes can attract dollar hot capital inflows and prompt domestic de-dollarisation but Pakistan isn’t there yet.

Beyond a certain threshold of 15-17% interest rate, marginal utility of interest rates decreases in controlling imports. Pakistan already ranks 168th with a paltry 18% imports-to-GDP ratio. You cannot compress the compressed further. Focus on exports.

Recent crackdown on exchange companies has sent a strong signal by bringing dollar rates from Rs335 to Rs305/PKR in open market. Clearly, the thinly fragmented exchange market is impacted more by manipulation from speculators.

SBP’s interest rate hike cannot achieve what the fear of stick from law enforcement agencies has. Yes, the recent T-bill auction appears to be signaling that lenders demand another Rs150-200-basis-point hike and with heavy borrowing, borrowers can’t be choosers.

Nevertheless, a further hike will damage the people and government more than controlling inflation or reviving investor confidence.

The writer is an independent economic analyst


Published in The Express Tribune, September 11th, 2023.

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