Should we be forced to eat less or produce more?
What Pakistan urgently needs is supportive measures from the government in the form of supply side policies.
The State Bank recently bumped up the discount rate by 50 basis-points to 13.5 per cent. Although there has been a lot of hue and cry over the recent increases in interest rates from different quarters of the business community, the average citizen remains confused about what all the commotion is about.
The discount rate is simply the interest rate which the central bank of any country charges its borrowers – typically commercial banks and other financial institutions.
More importantly, the discount rate serves as the ‘benchmark cost of capital’ for businesses and investors when they are evaluating what to do with their money.
If the net present value of future ‘discounted’ returns is negative, investors will shy away from putting money into a project. Simply put, an increase in discount rates translates into the present value of future returns being lesser.
On the other hand, the State Bank of Pakistan (SBP) increases discount rates in order to limit money supply in the market in an effort to control spending and keep a check on inflation.
While it is common in several countries to increase discount rates in order to curb inflation, the practice is clearly not without drawbacks.
By increasing the cost of borrowing for financial institutions, the latter would eventually pass on the burden to businesses and consumers in the form of higher interest rates on loans, credit cards, house financing, and so on.
Some reports suggest that local commercial banks have added upto one per cent to their charged interest rates which range between 15 and 18 per cent as a result of the latest hike by SBP.
Borrowers who are already tied up on loans based on variable rates will have to make higher interest payments while new borrowing might be given up altogether.
This will not only have an adverse impact on consumption but also investment, as forgone income on higher interest payments or simply lack of new borrowing affects all industries.
Both investments and consumption will fall, making the country economically worse off and eventually affecting the population’s quality of life.
Industries may earn lesser profits and quality of production and service might be reduced from the lack of investment. Investors may also prefer to take their capital out to other profitable destinations.
The long-term consequences could be more unemployment, feeble economic growth, lesser taxation revenues for the government (which is already in deficit) and weaker exports.
It is not hidden that the government has miserably failed to curb inflation and discount rates in Pakistan are one of the highest in the world (India eight per cent, Bangladesh five per cent and China 1.5 per cent). The combination of contractionary fiscal (higher tax rates) and monetary (higher discount rates) policies has failed to achieve the objective of bringing inflation down to single digit levels.
In fact, they seem to be counter-productive to the well-being of the domestic economy.
What Pakistan urgently needs is supportive measures from the government in the form of supply side policies which would help boost productivity and increase available output.
These policies could involve funding and subsidies for skilled education, seed-financing for setting up new production facilities and encouraging home-grown industries to flourish to ease out reliance on imported products.
Published in The Express Tribune, October 18th, 2010.
The discount rate is simply the interest rate which the central bank of any country charges its borrowers – typically commercial banks and other financial institutions.
More importantly, the discount rate serves as the ‘benchmark cost of capital’ for businesses and investors when they are evaluating what to do with their money.
If the net present value of future ‘discounted’ returns is negative, investors will shy away from putting money into a project. Simply put, an increase in discount rates translates into the present value of future returns being lesser.
On the other hand, the State Bank of Pakistan (SBP) increases discount rates in order to limit money supply in the market in an effort to control spending and keep a check on inflation.
While it is common in several countries to increase discount rates in order to curb inflation, the practice is clearly not without drawbacks.
By increasing the cost of borrowing for financial institutions, the latter would eventually pass on the burden to businesses and consumers in the form of higher interest rates on loans, credit cards, house financing, and so on.
Some reports suggest that local commercial banks have added upto one per cent to their charged interest rates which range between 15 and 18 per cent as a result of the latest hike by SBP.
Borrowers who are already tied up on loans based on variable rates will have to make higher interest payments while new borrowing might be given up altogether.
This will not only have an adverse impact on consumption but also investment, as forgone income on higher interest payments or simply lack of new borrowing affects all industries.
Both investments and consumption will fall, making the country economically worse off and eventually affecting the population’s quality of life.
Industries may earn lesser profits and quality of production and service might be reduced from the lack of investment. Investors may also prefer to take their capital out to other profitable destinations.
The long-term consequences could be more unemployment, feeble economic growth, lesser taxation revenues for the government (which is already in deficit) and weaker exports.
It is not hidden that the government has miserably failed to curb inflation and discount rates in Pakistan are one of the highest in the world (India eight per cent, Bangladesh five per cent and China 1.5 per cent). The combination of contractionary fiscal (higher tax rates) and monetary (higher discount rates) policies has failed to achieve the objective of bringing inflation down to single digit levels.
In fact, they seem to be counter-productive to the well-being of the domestic economy.
What Pakistan urgently needs is supportive measures from the government in the form of supply side policies which would help boost productivity and increase available output.
These policies could involve funding and subsidies for skilled education, seed-financing for setting up new production facilities and encouraging home-grown industries to flourish to ease out reliance on imported products.
Published in The Express Tribune, October 18th, 2010.