Against norms, the 6M KIBOR rate has been below the discount rate since January even as the policy rate has been slashed twice during the period. History suggests that whenever real interest rates are well in the green, the policy rate no more remains a benchmark to determine market rates. The real interest rates, based on headline inflation, increased from two percent to five percent in the last 12 months.
This is reminiscent of the 2002-04 period when the gap between market rates and the policy rate had significantly widened. SBP kept its policy rate constant at 7.5 percent for about three years while market rates were much lower. Foreign inflows were relatively high during that period as capital poured into the country and credit demand did not keep pace with this supply. The excess supply of money drove down the rates to as low as one percent. The economy was going through a monetary hangover.
Perceptions take time to change and economic players took their sweet time to internalise the improvement in macroeconomic indicators. There are parallels to draw from that experience that can be used to predict the economic situation in 2015-16 as macro indicators are improving but market pundits are as yet unsure of the sustainability of this economic recovery.
The market dynamics are also different now. Yes, the foreign flows are pouring in - NFA to NDA ratio has improved significantly in the last 12 months and is likely to remain better. But there are not any investment flows. Instead the money flowing into the country is in the form of grants from multilateral agencies, bilateral friends or loans. The domestic supply is chocked as energy bottlenecks are hindering capacity expansion - this wasn't the case in the early 2000s.
So, it's better to tread cautiously. The problem with higher foreign inflows is that they generate domestic demand but with supply bottlenecks the gap is met by higher imports - thus widening the trade deficit. And even the domestic production rises, the chances of imports growth to outpace exports is high as, according to manufacturing census, the exports' coefficient to production is less than that of imports.
The policy tool to counter this trade imbalance is the exchange rate. Let the currency devalue and exports will gain competitiveness while imports get dearer. But the policy makers are opting for the exact opposite choice as they are trying to ensure that the currency does not shed value from current levels. The same was done in the Shaukat Aziz era where the government kept the local currency pegged at Rs60 to the US Dollar. But when the devaluation kicked in, the Rupee shed over 30 percent in no time.
At that time, the economy fell prey to Dutch Disease; in the last decade when all of a sudden foreign flows poured in, in the form of aid and investment, exchange rate started to appreciate. Imports were becoming cheaper and exports suffered in the process. Unfortunately, no lessons were learnt as the same is happening again now as the exchange rate is being artificially kept around Rs100 per USD for the last 12 months.
Thanks to oil prices which are down to half, the impact is not visible yet in imports. However, exports are stagnant. LSM growth is showing that textile and other exporting sectors are in the hot tub. The same is the fate of the food group despite a growing middle class. That is why imports of food items are outpacing the growth of other imports and on the other hand, exports of food items are falling. The point is that imports are becoming cheaper and domestic production is becoming uncompetitive. This has to change and policy tools should be used to deliver that change.
But interest rates are coming down irrespective of how much the central bank eases the policy rate. The job at hand is to ensure that cheaper credit drives the growth of businesses. Unfortunately, that is not happening as the growth in private credit this fiscal year to date, is half of what it was in the similar period last year. In the absence of real economic activities, the lower rates may result in speculative investment in the other asset classes like real estate and the stock market.
Anyway, market rates are falling faster than the policy rate. The secondary market yield of 6M paper is already below eight percent and the latest discount rate cut will take it further down. Market rates are following the open market operation rates as OMOs are effectively providing liquidity in the market - its ceiling has revised down by 50 bps to eight percent. However, the prevailing rates were already around eight percent and they make come down around 7.5 percent now.
Inflation is also trending down so interest rates will likely continue the southward journey but the economic impact will only be possible once private credit picks up. Without this happening, the SBP may continue to inject money through OMOs and the banks will keep on looking for government papers to invest in it.