SBP’s discount rate hike

It appears that the battle between the finance ministry and the State Bank of Pakistan (SBP) is set to continue for some time now. For the second time in a row, the central bank used its monetary policy meeting to increase its benchmark discount rate — the rate at which commercial banks can borrow from the SBP — by half a percentage point. The rate now stands at 14 per cent, close to its 2008 crisis-level peak of 15 per cent.

Yet the central bank has been very blunt about why such a rate increase was necessary. Inflation has been spiralling out of control, largely due to over-borrowing by the federal government. The State Bank has a single over-riding mandate: to control inflation. Its single biggest tool in doing so is interest rates, which it has used somewhat timidly in the past but is now beginning to get more comfortable with. When inflation rises, the SBP raises interest rates in order to curb borrowing and slow down price rises.

The business community has been reasonably irked by the rise in the cost of borrowing. But they should realise that the central bank is simply responding to the constant depreciation in the value of the rupee that has been precipitated by unchecked government deficits. The government does not actually spend too much money, just much more than it takes in as revenues. Think of inflation, then, as an alternative to the taxes that nobody seems willing to pay. Unfortunately, this replacement for taxation has a tendency to hurt the poor infinitely more than it hurts the rich or even the upper middle class.

Economists have pointed out that the real interest rate in the country — the nominal interest rate minus the rate of inflation — is actually still negative. This means that in real terms, lending is still an unprofitable enterprise. Yet we acknowledge that even nominally high interest rates are damaging to the economy. The solution, however, is not to decry the central bank’s moves, which seems to be the default response of many commentators, but to support an increase in tax revenues, such as the reformed general sales tax bill currently in parliament. Only a balanced federal budget can guarantee manageable levels of inflation.

Published in The Express Tribune, December 1^st, 2010.