To revise or not: Workings of the monetary policy
The policy rate, announced every two months, is the interest rate at which commercial banks are allowed to borrow from the central bank’s discount window on an overnight basis. The central bank uses this tool to control inflation by changing the level of money supply in the economy.
Typically, central banks increase the discount rate, which is also referred to as monetary tightening, when inflation is on the rise. Conversely, they lean towards monetary easing by lowering the discount rate if the CPI is down in order to boost credit off-take in the economy.
CPI in October clocked up at 5.8% on a year-on-year basis mainly because of lower food inflation and a high base effect recorded in October 2013. The average inflation in the first four months of the current fiscal year has been 7.09% as opposed to 8.32% recorded in July-October 2013.
“A sharp decline in CPI for October has substantiated our conviction on a discount rate cut as early as in November,” Farid Aliani of KASB Securities said while noting the possibility of a 50 basis points revision in the upcoming monetary policy. The discount rate currently stands at 10%. The SBP last revised it in November 2013 when it increased the rate by 50 basis points.
The real interest rate in the economy, which is the lending interest rate adjusted for inflation, currently stands at 4.18%. It is considerably high, as the average real interest rate has ranged between 1.5% and 1.8% in the last three years.
According to Global Securities, the SBP had cut the policy rate by 50 basis points to reduce the real interest rate in May 2013 when the interest rate and inflation were 9.5% and 5.13%, respectively. “Hence we can expect the same trend going forward even in the presence of political uncertainty,” it said.
While high interest rates after adjusting for inflation encourage savings in the economy, analysts believe they also discourage private-sector borrowing. High real interest rates result in dampened credit-uptake, thus slowing down growth in the gross domestic product.
Elixir Securities believes a ‘potent case’ for a rate cut exists for the SBP. Using the July-October average inflation figure of 7.09%, it says the real interest rate clocks in at 2.9%.
“However, the finalisation of International Monetary Fund (IMF) review, foreign exchange inflows from the Oil and Gas Development Company (OGDC) transaction and a sustainable level of external account will remain key factors to the final decision,” it added.
Implications for the
banking sector
A revision in the discount rate has a direct impact on the earnings of commercial banks. Other than affecting banks’ lending and deposit rates, the discount rate plays a key role in determining their investment income.
According to Aliani of KASB Securities, each bank’s reaction to a discount rate cut will be a function of the duration of investment portfolio, the bank’s deposit mix, and the diversity of its operations in terms of geographical presence and conventional/Islamic mix.
Earlier on, banks used to have 8%-12% earnings sensitivity to a 50 basis points movement in the discount rate, he said. But the level of sensitivity changed after the minimum deposit rate regulations were enacted in 2013, and banks started focusing on locked investment yields in Pakistan Investment Bonds (PIBs), he added. Aliani says a sample of 12 top - and mid-tier banks has an earnings sensitivity that ranges from negative 5% to positive 6%.
THE WRITER IS A STAFF CORRESPONDENT
Published in The Express Tribune, November 10th, 2014.
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