Pakistan’s Interest Rate and Monetary Policy 2020 – Current Situation and Way Forward

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SBP Reduces Discount Rate to 12.5% in Mar-2020

There has been a lot of criticism and pessimistic hue over the recent discount rate increases by State Bank of Pakistan (SBP) from 5.73% in January 2018 to 10% in January 2019. The rate has been further increased to 13.25% in July 2019. SBP released Monetary Policy Statement for March 2020 and has reduced the rate to 12.5% in March 2020. The increased discount rate raised the borrowing costs for government, businesses and general public and slowed the GDP growth of Pakistan which was part of government’s monetary tightening policy to curb further inflation. However, to fully understand the impact of SBP’s policies on economy, we need to first understand the concept of interest rates and how monetary policy evaluates policy rates in Pakistan

To What Extent SBP affects Interest rates, Money Supply and GDP Growth?

Unlike the common belief, State Bank of Pakistan (SBP) does not dictate any specific targets for economic indicators like Inflation, Economic Growth, Exchange Rate, and Purchasing Power. SBP is responsible for controlling and stabilizing the impact of inflation in economy and it can be inflation rate in part dictates the monetary policy of Pakistan

Before 2009, there used to be only one discount rate by SBP that was implemented across the institutions for borrowing and lending money and due to money supply excess and shortage with commercial banks and SBP, the rates fluctuated a lot that in turn diminished the policy stance of SBP and made markets volatile. However, in 2009, SBP introduced ‘Interest rate corridor’ in Pakistan to separate policy rate from discount rate while introducing ceiling and floor for discount rates that lies within a certain width of policy rate, (currently 200 basis points or 2%) and thus, made liquidity management and interest rate fluctuation stable (State Bank of Pakistan, 2020).

The discount rate is generally higher than the policy rate while the inter-bank interest rate is the KIBOR (Karachi Interbank Offered Rate), the rate at which commercial banks lend money to other banks and can be higher or lower than discount rate within the interest rate corridor. When there is shortage or excess or liquidity in the market, banks go to SBP or other banks for borrowing money at discount rate or KIBOR in return for T-bills.

Understanding Difference between Policy Rate and Discount Rates

While often confused as same rate, the SBP’s Policy rate is different than the Discount Rate. Currently, Policy rate by SBP is 12.5% while Discount Rate is at 13.75%. The policy rate refers to interest rate that serves as a signal to SBP’s stance on monetary policy and represents rate that SBP intends to maintain in fiscal session and based on this rate, interest rates are decided that allows lending and borrowing of money within the corridor limits to reduce liquidity volatility.

The discount rate on the other hand is the repo rate, a rate at which SBP lends money to commercial banks to meet liquidity requirements in exchange for pledging of short term securities as collateral. There is another rate called ‘Reserve Repo’ or ‘Discount Rate Floor’ that allows commercial banks to park their excess liquidity with State Bank overnight, usually to increase money supply in market. Both discount rate and discount rate floor are overnight borrowing and lending rates which manages the shocks from liquidity crunch or excess supply in financial institutions that in turn affects the economic activities in country.

SBP Policy Rates and their Significance for Economy

When we see developed economies, the interest rates are much lower compared to Pakistan, for instance, the current policy rate is 1.3% in USA, 0.5% in Australia, 0% in Europe and Sweden while -0.1% in Japan. In developing economies the interest rates are around 5% to 7% like Russia, India or South Africa.

On the other hand, emerging economies like Pakistan have much higher interest rates. The interest rates for developing economies go as high as 29% (Venezuela), 21% (Costa Rica) or in between like 12.5% for Pakistan and 16% for Mali (Global Rates, 2020). However, as with interest rates, there is a huge difference between inflation in these countries as well. Countries with high inflation rates tend to have high discount rates as central banks use high interest rates to curb the impact of high inflation on economy also referred to as ‘Monetary Tightening’.

Overheating of Pakistani Economy – A Major Contributor towards Current Discount Rate

Pakistan currently has one of the highest interest rates in region. The high inflation rate of 9% in 2019 and current rate of 13% led SBP to raise policy rates in 2019 to control the overheating of economy. During period of high inflation, there is less demand for goods and services in economy and by making capital or money more expensive, SBP aimed at slowing down demand which can lead to decline in prices.

With increased interest rates, the cost of living and doing business increases. Even for a salaried class person, who doesn’t own business, the disposable income declines, his credit cards become expensive, installments become expensive and thus, spending declines which reduces demand and eventually manufacturers have to reduce prices. However, if rates are increased further, it can be counterproductive as manufacturers can shut down businesses or run out of businesses if they cannot maintain sellable price. Whenever there is monetary tightening, there is decline in GDP so slower GDP means per capita income is not rising and a country can enter into a recessionary phase, given that the state bank keeps increasing policy rate.

The inflation rate in Pakistan remained at lower side during 2015 (3%) and onwards till 2018 when it started to rise again. The GDP growth rate was positive during the years, however, as growth increases economies tend to overheat and GDP slows down and inflation surpasses the GDP growth rate where it should be lower than GDP rate. In 2017, the GDP growth rate was 5.55% while inflation was 4%, in 2018 however, the GDP growth rate was 5.83 and inflation was 5%, only 0.8% lower than GDP rate and thus, the SBP started raising discount rate from 6% on January 2018 to 10% by end of year 2018. The revision in policy rate of 2019 to 13.25% was also a step to cool down the economy by lowering the GDP growth rate and thus, inflation which reached a high of 13% in 2019. In March 2020, GoP reduced the policy rate from 13.25% to 12.5%.

How Imported Inflation affected SBP Policy Rate in 2019-2020

In Pakistan, a common type of inflation is the imported inflation. Imported inflation refers to increase in prices for imported products and as our biggest share of imports are the Mineral fuels specifically oil (28.4%), when oil prices rise in doubles, as it did in 2009 to 2013 and again in 2017, inflation also rose along with serious impact on balance of payments and current account in Pakistan.

Pakistan saw no inflation in manufacturing sector as cement and steel are locally manufactured, however, with oil, transportation costs increase which lead to rise in food and non-food item price increases. That’s imported inflation. We run a perpetual current account deficit so when international commodity prices go up local prices go up and it put strains on our foreign reserves. As Pakistan’s foreign reserves are highly dependent on remittances and IMF loans, whenever there is strain on foreign reserves due to high imports, State bank recommends devaluing Pakistani currency to adjust reserves. To digest the impact of currency devaluation on inflation, State Bank of Pakistan increases the policy rate to absorb the shock of imported inflation.

Why We Can Expect Lower Discount Rates in 2020

The official estimates by agencies like IMF and SBP forecast a downward cut in interest rates to 12% in beginning of 2020 and further sharp decline July onwards (IMF, 2020). The expectations in capital markets are around 7% for year-end 2020. The reasons for such lower rates are that market experts believe that Pakistan has successfully combated underlying causes of inflation and with oil prices hovering around $30-$40 per barrel and expected to either remain there or go down, we can see a positive impact on our current account deficit. SBP has already incorporated the devaluation of Pakistani currency and is building strong foreign reserves by passing impact of inflation on the consumers through cutting subsidies and raising prices under IMF suggestions, which was a one-time hit.

Moreover, in order to maintain the required 200 basis point of real interest rate (Discount rate – Inflation) in the country SBP needs to lower the discount rate. The inflation for year 2020 is expected to go down as low as 7% to 8% for which SBP will have to revise discount rate to 9% to 10%. Oil is already down sharply and markets are seeing rates to go down quicker than expected and while expectations for a first move towards expansionary policy were in July or December 2020 but now capital markets are suggesting at least a 100 basis point rate cuts in the SBP policy session of 17th march. With decrease in policy rates, the rates of subsidized loan facilities by SBP including Long Term Finance Facility (LTFF) and Export Refinance Facility (ERF) are expected to go down even further thereby, hinting at expanding industries in the country.

Current Bond yields also Hint at Lower Policy Rates in Pakistan

Lastly, apart from future expectations and analysis, another factor that has been taken as major sign of future policy rate cuts is the Bond market of Pakistan. The Bond yield in secondary market currently shows steep inverted yield curve. The bond yield curve is an indication of what players secondary markets are expecting. The Bond yields shows a very steep interest rate scenario where the 10-year bond is trading at 200 to 300 basis point below the policy rate where generally it is 100 to 200 basis points above the policy rate as it represents taking a longer risk on securities. The current yield is 10.5% for 10-year bond, 10.5% for 5-year bond and 11.5% for 3-year bond, all lower than policy rates (World Government Bonds, 2020). Therefore, the market has already incorporated a cut of somewhere around 3% in secondary market yield.

Update April 2020: State Bank of Pakistan Announced 200 BPS reduction in Interest Rate

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