Need for change

The earlier the government reduces bank interest rates, the better for economic growth
By Huzaima Bukhari an Dr Ikramul Haq
Adviser to the Prime Minister on Finance Shaukat Tarin, speaking at the top 25 Companies Awards for 2006 and 2007, organised by the Karachi Stock Exchange (KSE), promised that the discount rate would come down to single digit by August and would further reduce to about 6 percent on average in 2010. A day earlier, State Bank of Pakistan (SBP) Governor Salim Raza, in an interview with Reuters, said the interest rates in Pakistan should come down over time – given that price rises remained lower and core inflation continued to stabilise.
These are encouraging statements. One hopes they materialise, because due to high interest rates our economic growth is being seriously hampered. During acute recession, it is not possible for anybody to do business with interest rates as high as 16-18 percent. The government itself is borrowing funds at enormously high cost making things worse. With unbearable debt servicing cost, the viability and profitability of organisations is crumbling.
The SBP is going to announce a monetary policy statement next month and it is likely that the key discount rate will be reduced to an affordable level. Inflation in Feb rose to 21.07 percent from a year earlier, after declining month-on-month for three months, after hitting a record high of 25 percent in Oct 2008. However, the SBP governor observed "it was a 'one-time' rise and the downwards trend in inflation month-on-month would continue." Raza was optimistic that core inflation would stabilise, rather drift down, in the next few months. Independent analysts also endorse this view.
However, interestingly, neither the adviser to the prime minister on finance nor the SBP governor has realised the real malaises of our economy. They failed to mention and acknowledge the fact that domestic debts surged by 10 percent to the record level of Rs3.6071 trillion during they first seven months (July 2008-Jan 2009) of the current fiscal year (FY09), from Rs3.2661 trillion on June 30, 2008 – showing an increase of Rs341 billion courtesy the ever-rising fiscal deficit and slow foreign inflows. The slow inflows on the back of stalled privatisation process during the past one-and-a-half years and less than target revenue collection have compelled the government to borrow from the domestic market at a very high rate.
The rising fiscal deficit and high current expenditure also raised the government's reliance on domestic debts, as well as on external debts, to meet its financial requirements. A SBP report admits that the country's overall stocks of domestic debts – including permanent debt, floating debt, and un-funded debt – have registered a growth of 10.44 percent during the first seven months of FY09. The burgeoning debt burden with high interest rate will certainly increase the fiscal deficit, because the cost of debt serving is going to be monstrous in coming years.
The tightening of fiscal policy – keeping high interest rates intact – has been termed by the Commerce Ministry a failed policy, because it has been unable to control inflation and to strengthen trade balance. According to a media report, the ministry conveyed that "during the first nine months of 2008, tight monetary policy could not give its desired results, as the core objective of controlling inflation and narrowing of trade balance was not achieved."
The Commerce Ministry reportedly took up these issues with Prime Minister Yusuf Raza Gilani in a recent inter-ministerial meeting. The ministry has very strongly demanded lowering of interest rate for making exports competitive in the international market and providing liquidity to exporters. The ministry recommended to the policymakers that for the next quarter an expansionary monetary policy should be adopted – interest must be slashed so that the decline of exchange rate could be reversed.
As agreed with the International Monetary Funds (IMF), the SBP has been pursuing a tight monetary policy, aimed at controlling inflation and trade deficit. While in the rest of the world the reserve banks considerably lowered discount rates and the government announced generous bailout packages, the SBP revised the interest rate upwards, with the view that this would attract foreign capital for higher return, which would not only decrease the inflation rate but would also decrease the exchange rate. No such thing has happened. The experts are of the view that international economic situation negatively affected the export and import performances of all countries, and caused downward trend in international aggregate demand. Consequently, a significant decrease in imports was observed. The same international and national economic factors have adversely affected Pakistan's trade balance too.
According to the Commerce Ministry, higher interest rate induces foreign capital inflow, which further appreciates domestic currency; consequently, the exportable commodities become expensive in the international market. Moreover, higher interest rate increases export finance rate and makes the capital input more expensive, which increases cost of production and makes it less competitive in the international market. Pakistani exporters are under great stress because the country's competitors have decreased their interest rates considerably. This has helped them to decrease their capital input cost and depreciate their currencies. As a result, their export products are becoming more competitive in the international market as compared with that of Pakistan.
Many quarters are critical of government for not brining down the interest rate even after decline in inflation and improvement in balance of trade position. It is important to note that these positive results are not primarily due to the tight monetary policy; there was a sharp decline in the international oil prices, as well as that of edible oils, which significantly reduced the balance of trade gap and stabilised domestic prices. Exports during the first seven months of FY09 increased to $10.934 billion from $10.122 billion in the corresponding period of FY08, registering an increase of $0.812 billion, or 8.0 percent. Slow growth in exports was due to power shortage, rising domestic cost of production, chilling effect on production-enhancing costs and retarding exports.
The major items showing increase during July-Dec 2008, as compared with the corresponding period of last fiscal year, were raw cotton (229.9 percent), rice (109.5 percent), cement (91.6 percent), engineering goods (89.4 percent), petroleum products (27.5 percent), chemicals (24.6 percent), towels (18.7 percent) and cotton cloth (13.0 percent). Major items showing decline during July-Dec 2008, as compared with the corresponding period of last fiscal year, were petroleum top naphtha (36.5 percent), carpets (24.5 percent), leather tanned (17.7 percent), cotton yarn (14.7 percent), readymade garments (12.2 percent), leather manufactures (12.1 percent) and bed wear (9.3 percent).
During the first seven months of FY09 (July 2008-Jan 2009), exports increased to $21.661 billion from $20.480 billion during the corresponding period of FY08, registering an increase of 5.8 percent. On the other hand, growth in imports slowed to 5.8 percent during the first seven months of FY09, as compared with 18.9 percent during the corresponding period of FY08. As a result, trade deficit during this period grew by only 3.6 percent, as compared with 35.5 percent in the corresponding period of the last fiscal year. The increase in imports growth was attributed mainly to the inflated petroleum group imports on the back of high international oil prices, import of wheat in the wake of flour crises, and increase in the import of power generating machinery.
The major items contributing to an increase in the import bill were wheat (810.7 percent), power generating machinery (108.8 percent), construction and mining machinery (51.6 percent), petroleum group (38.6 percent), other machinery (25.0 percent), electrical machinery (22.9 percent), iron and steel (12.2 percent), palm oil (7.9 percent), and chemicals (3.9 percent). The major items showing decline in imports during July-Dec 2008, as compared with the corresponding period of the last fiscal year, were aircraft, ships and boats (69.4 percent), telecom (45.1 percent), fertiliser manufactures (31.2 percent) and road motor vehicles (24.8 percent).
All these indicators suggest that there is no justification in keeping the interest rates high; a tight monetary policy should not be growth retarding. Now that inflation is moving down and the current account deficit has reduced to $500 million from $2.1 billion – a fall of nearly 75 percent – there is an urgent need to cut discount rates considerably. It would certainly help the ailing economy in recovering fast.