Interest rate hike and devaluation are not the solutions!
Shahid Sattar & Madiha Nisar
The process through which changes in the monetary policy stance affect the aggregate demand and inflation is termed as the transmission mechanism of monetary policy. Interest rate channel is one of the five channels through which the monetary policy transmission works.
Claiming that inflationary pressures may be building, the State Bank of Pakistan has raised interest rate by a cumulative 4.25 percentage points in five rounds since January 2018 in an effort to rein in economic growth.
The state bank of Pakistan first hiked interest rates by 25 basis points in January this year, followed by 50 basis points in May, 100 basis points in July and 100 basis points in September.
Contrary to rational expectations of a moderate hike in policy rate, hawks of SBP came up with 150 bps increase on November 30th to take the policy rate at 10 percent while the core inflation is at 8.3 percent as of October 2018 and unemployment rate has reached a whopping 9 percent.
The latest increase of 150 bps in the interest rate is aimed at containing inflation, while the previous hike of 275bps was targeted at taming the unsustainable current account deficit, which ate up the country’s dollar reserves and posed import payment and debt repayment challenges.
But history shows that previous 275 bps hike in interest rate from May to October 2018 had no impact on inflation as it continued to inflate. Moreover, data of previous ten years shows that every policy rate hike in past years was accompanied with a more or less equal hike in inflation rate. The highest inflation rate of 17.19 percent was experienced in 2009 when interest rate was 14 percent, highest in last ten years. Previous data proves that inflation and interest rates have a side by side relationship, any increase in any of one will also cause an increase in other.
The target policy rate affects all other interest rates in the economy, eventually making it more expensive to borrow, and serving as a brake on the pace of economic activity. Typically, higher borrowing costs slow the economy by forcing consumers and businesses to cut back on spending and investment. But the impacts of rising interest rates affect different groups in different ways.
The growth momentum has already slowed down, which is visible from GDP growth forecast for fiscal year as it is downgraded to 5pc. In the last monetary policy statement released in July, the SBP had forecast GDP growth at 5.5pc while Asian Development Bank has anticipated it to be 4.8 pc for FY19. The continuous downgrades in the growth forecast suggests a sharply decelerating economy. The interest rate hike has added 0.75% of gross domestic product (GDP) to the budget deficit.
The other shock to growth is possibly coming from less than targeted cotton production, which would not only hurt agriculture growth but also have its toll on services growth.
The rate hike will most adversely impact the federal government by increasing its debt servicing cost. Increase in policy rate hike plus continuously depreciating currency will make it difficult for the government to curtail the fiscal deficit.
According to experts, a 1% increase in interest rate increases the cost of debt servicing by roughly Rs180 billion. The claim is proved by the history as after 250 bps increase in interest rate from May to September, Pakistan’s debt and liabilities surged to 30.87 trillion with an addition of 0.98 trillion within three months only (July-September). Gross public debt which is sole responsibility of government has also surged by 0.83 trillion within three months. The adverse impact of the latest policy rate hike on government’s debt servicing will be visible in upcoming data release of SBP.
Owing to higher interest rates and currency depreciation, Pakistan’s debt as well as debt servicing cost will further go up in the current fiscal year even if no fresh loan is taken.
Furthermore, in alliance with universally declining trend, and in response to increased policy rate by an aggressive 150 bps, the stock market in Pakistan remained volatile the past week, as the benchmark KSE 100 index made a net loss of over 1,800 points, slipping below the two touchstones of 40,000 points and 39,000 points.
It is said that there is a direct relationship between interest rates and the value of domestic currency. All else being equal, hike in interest rates leads to currency appreciation as investors see higher returns on their investments. But this assertion is not true for the economy of Pakistan as previous contractionary measures always resulted in more inflation and currency depreciation in Pakistan. Following the previous interest rate hikes the rupee has depreciated by almost 26 percent since January 2018.
In addition to nominal exchange rate, official data released by State Bank of Pakistan (SBP) revealed that Pak Rupee’s Real Effective Exchange Rate index (REER) has also decreased by 2.68 per cent in October, falling to a value of 108.1450 from 111.1276 in September.
Thus government’s claim that interest rate hike is to contain inflation and currency depreciation is not tenable. Take the example of the textile sector which has traditionally contributed more than 60 percent of the exports of Pakistan. The devaluing impact on the industry contrary to conventional wisdom is marginal if not already negative. This is because 80 percent of the input cost, cotton, energy, MMF, machinery and spare parts are all imported and dollar dominated.
The only rationale for the devaluation appears to be import curtailment. But even the imposition of RDs and currency depreciation failed to achieve this target in past. Despite high regulatory duties and currency devaluation, imports have increased by almost 13pc in fiscal year 2017-18 while exports improved by only 8pc. Considering inelastic nature of imports depreciation of currency will only contribute to increase in imports bills and will also violate the world trade organization’s treaties.
Increasing exports through devaluation is highly contentious. The ground realities suggest that long-term policy of maintaining the cost of doing business competitive to other countries, provide access to capital tax expansion and new industry and have a progressive outlook through innovation and new methods.