Wednesday, March 12th, 2025
Home »Stocks and Bonds » Pakistan » Discount rate hike unavoidable?

Not very long ago, the State Bank of Pakistan looked confident about economic recovery and inflation numbers. This could have never been possible without enforcing fiscal discipline, although the government continues to borrow heavily. Moreover, food prices are on the constant rise and a hike in energy prices is unavoidable to meet the foreign donors' demand.

But the recovery dream was shattered by this year's floods and since then the country's economic conditions started deteriorating. At present, it is extremely difficult for the authorities to manage economy due to crop losses and rising global food prices, which is putting immense pressure on inflation that may surge to around 16 percent by December, 2010.

The trend, therefore, suggests that the Pakistani Central Bank may be forced to hike its discount rate by another 1/2 percent to 1 percent. If the SBP decides to hike discount rate by 50 basis points, now another hike of 50 percent in January 2011 cannot be ruled out if inflation is not tamed below 15 percent. The needs to rethink at its monetary measures and act in accordance with market needs instead of going by the books by hiking the Discount Rate on a routine basis on every inflation announcement.

Inflation is surely the responsibility of SBP, but the Central Bank is also responsible for price stability, economic growth and job creation. Unfortunately, however, they are not visible on the horizon.

The SBP has three instruments that it can use judiciously and effectively. They are Reserve Requirements, Discount Rate and Open Market Operations. The Central Bank's policy of taming inflation by hiking the rate has failed to produce the desired results. In such a situation one does not understand SBP's dual policy of policy tightening and simultaneously transfusion of liquidity - a liquidity management from SBP's perspective.

The big question on everyone's mind is about SBP's tightening stance of hiking the rates to an extraordinary high level and at the same time it injects rupee liquidity through a Sell/Buy swap, or through its open market operation, which is a clear negation of its tighter policy stance. The recent trend has shown the figures reducing from the highs of USD 2.4 billion to USD 1.4 billion. Why can't SBP allow banks to use its discount window, when banks are loaded with government securities?

Furthermore, liquidity injection into the interbank market by the Central Bank with its tightening approach becomes questionable, because the currency in circulation has swelled to a new all time high of Rs 1.538 trillion, which is almost 32 percent of the total Time and Demand Liability (TDL).

This constant rise in currency in circulation is very alarming. One wonders why this damaging trend is not questioned. We hardly hear from the SBP any measures that it has taken to cut down the currency in circulation. Moreover, IMF has also not taken a serious note of this issue, despite its stubborn stance to reduce deficit at the cost of growth and job losses.

SBP has created doubt the effective use of its monetary tool. Instead of creating space to stimulate growth and create jobs opportunity in private sector, it has been found injecting liquidity to help banks invest in government instruments to bring down the deficit to meet IMF demand.

For banks, it is a very comforting factor to invest in highly attractive risk-free short-term government securities that offer exorbitant returns. Banks are taking good advantage of fortnightly T/bills auctions, as banks comfortably get fresh inventory at higher yields. Banks are well aware that SBP cannot afford scratching of auctions on a frequent basis.

Banks snubbed SBP/MOF by demanding higher PIB yield in two previous auctions held on July 27 for Rs 20 billion and on August 18 for Rs 25 billion. Both the PIB auctions were scratched by SBP. In the 3rd PIB auction held on October 13, SBP/MOF had accepted a small amount of Rs 5.75 billion against the target of Rs 20 billion. Rejection of two PIB auctions and only acceptance of 37 percent of the targeted amount of Rs 135 billion in the last MTB auction was received as a surprise move by the market. Since the re-launching of electronic bond about 10-months ago, SBP is struggling without any success to develop a debt market due to extremely thin interbank trading activity.

For trading purpose, benchmarking is an important feature and scratching of PIB auction sends a wrong signal to the market participants and bring its credibility under doubt like it happened in the past. Net outcome is that the current holding of government securities as of November 15, 2010 has surged to Rs 2.128 trillion, out of which MTB is Rs 1.526 trillion, PIB 508 billion and Sukuk Rs 94 billion. By end of June 2009, total holding was Rs 1.354 trillion, MTB was 885 billion, PIB's was Rs 440 billion and Sukuk was Rs 28 billion. Similarly, as of December 2008, total government securities holding was Rs 1.138 trillion, MTB 698 billion and PIB's 440 billion. With banks earning a spread of 7.2 percent and being provided cheap liquidity to purchase of Treasury Bills, it is a subsidy enjoyed by the banking sector.

State Bank of Pakistan should have opted for a tightening stance by hiking cash reserve ratio (CRR) instead of a sharp hike of discount rate, because prior to 2008 election, the sign were obvious that the country will not get easy access to foreign money. Remittances and exports are the only two major source of funding, out of which good part of remittance money is meant for consumer spending, which is another factor for the rise in currency in circulation.

SBP's priority should have been to provide cheaper funds to boost domestic demand and reduce production cost by effective use of its monetary tools. This situation has arisen due to poor monetary and fiscal policies of the past and delay in decision-making, causing a low revenue collection, higher spending and unnecessary subsidies.

Hiking of CRR would have discouraged excessive lending to private sector and the public sector, which is proving to be a very costly affair. By hiking CRR, banks would have been forced to offer better return to depositors. Banks would have refrained from risky lending. Some part of money from currency in circulation would have flowed down to the banking system. The savings ratio would have been much healthier and ultimate results would have been better inflation numbers. Globally, credit tightening by central banks is a very common and effective tool, and is result-oriented.

A word about SBP's Central Board and Monetary Policy Committee (MPC). Its job is to oversight the financial side, policy formation, and human resource management. It is also required to make audit an effective tool of overall management, and most importantly, oversee reserve management through sub-committees of all the above-mentioned heads. Similarly, MPC has a nine-person strong team consisting of two members from the board. There are two external economists in addition to four members representing SBP, chaired by the Governor SBP.

The board's composition and selection policy needs to be reviewed in line with the required capacity to appropriately appreciate the technical aspects and the challenges faced by the central bank. In this context, the present composition of one member from each province, three from the industries and one from MOF seems to give a right kind of flexibility to co-opted subject matter specialist which should be a preferred choice to represent central bank's board to deal with broader issues in relation to monetary, fiscal, banking and broader economic challenges perspective.

Though not visible, the quantum of current ongoing liquidity problem is extraordinarily large in size caused due to mild and soft policy approach adopted by the State Bank of Pakistan in providing credit. The perception about liquidity factor needs to be properly understood. It often leads to a question: how are the banks managing to invest in government securities in the absence of required liquidity?

The money invested in government securities is not generated through fresh bank deposits. Estimates show that annually roughly 8 percent or Rs 375 billion is generated from interest accrual and some part of the money consists of forced rollover at maturities, which is not a healthier sign for the banks' balance sheets. The reality is that for the past many years Pakistan's economy has been surviving on foreign investments and borrowings.

Mixing up liquidity with circular debt also requires some clarification. Circular debt is more to do with the credit facility limit available to a particular institution based on the size of its balance sheet than anything else, which means that if the limit is fully utilised the institution cannot get new funding.

It would not be wrong to say that economy has two major worries to look into. Going forward if the fiscal indiscipline follows the same trajectory the system may face yet again a liquidity crisis followed by a credit crunch. The banking system is struggling against three key challenges. They are a rise in NP's that has surged to 11 percent or Rs 508 billion. Currency in circulation that has jumped to 32 percent or Rs 1.538 trillion and a rise in bank deposits against interest accrual, which weaken the banks balance sheet. Therefore, the SBP board members are equally responsible for the past decisions and it is their responsibility to ring the alarm bell at an appropriate time.

Copyright Business Recorder, 2010


the author

Top
Close
Close