Borrowing cost: Rate cut – govt to benefit more than private sector

It may not stimulate significant fresh investment from private sector.

ISLAMABAD: The decision of the State Bank of Pakistan (SBP) to reduce the policy rate by 100 basis points to 8.5% comes on the back of a fall in inflation and a drop in global oil price.

This is in sync with leading central banks around the world. The European Central Bank (ECB) just announced to pump 1.1 trillion euros into the banking system to fend off price deflation and revive economic activity. In Europe, the yearly rate of growth of the Consumer Price Index (CPI) fell to minus 0.2% in December 2014 from 0.3% in November and 0.8% in December 2013.

In the face of it, the likely explanation given by economic advisers of the government for a cut in the interest rate is that this would induce investment, create more jobs and ultimately increase economic growth in the country.



However, after a close inspection of statistics, it can be seen that the biggest beneficiary of this reduction would be the government itself as it is the leading borrower.

According to November 2014 statistics released by the SBP, about 65% of total credit is allocated to the government. Thus, a reduction in interest rate would reduce the cost of borrowing for the government, which according to a report of the SBP released last month paid over Rs1 trillion in FY14 in interest charges as compared to Rs864 billion in FY13.

Therefore, the prime objective of improving the investment climate and encouraging private investment by reducing the interest rate from 9.5% to 8.5% may not be met.

At the moment, majority of commercial banks are reluctant to lend money to the private sector, especially newly established private businesses, due to the high amount of non-performing loans (NPLs). According to the SBP, local private banks have a 52% share in all NPLs of commercial banks.

As a matter of fact, the stock of NPLs in the banking system has doubled from 7% to 14%. Moreover, during the first half of FY15, total credit to the private sector was Rs153.7 billion whereas during the same period last year it was Rs234.8 billion, recording a 35% decline. This has happened despite a 37% increase in the agriculture sector credit.

It is highly unlikely that in the absence of visible improvements in energy infrastructure and business climate, the interest rate cut can trigger fresh lending.

According to Austrian economics, which presents a counter-narrative to Keynesian economics, a central bank-induced reduction in interest rate will also lead to credit misallocation whereby investment decisions of firms and individuals would not be on the basis of risk and return of a project.

If a low interest rate would be the main determinant of investment decisions, it would result in mal-investments and in the long run would add to the pile of NPLs. This intervention by the central bank is largely responsible for the infamous business cycle, or boom and bust cycle, and while it does raises the spectacle of investment, most of it is likely to go waste eventually.

In a nutshell, the decision of the reduction in interest rate will have no significant implications for the private sector in terms of fresh investments, though it will help in reducing the cost of borrowing both for the private sector and the government. However, the government will profit at the cost of savers and depositors in commercial banks, who will be left with reduced money in their accounts due to the interest rate cut.

Eventually, this decision will contribute to the erosion of real wealth, which citizens have earned. Seen like this, the decision will be a bad news.

The writer is the executive director of PRIME Institute, an independent think tank based in Islamabad

Published in The Express Tribune, February 9^th,  2015.

Like Business on Facebook, follow @TribuneBiz on Twitter to stay informed and join in the conversation.