With SBP policy rate at 13.25% and borrowing costs for many businesses well above 15%, recently there has been an increasingly loud drumbeat demanding that the SBP lower interest rates. This has culminated in a former International Monetary Fund official filing a petition with the Supreme Court to order the authorities concerned to cut interest rates, to save the government Rs1 trillion annually, and place capital controls to ensure orderly withdrawal of so called portfolio investments in treasury bills.
Dr Zubair Khan’s petition pleads, “The court may kindly order the federal government to lower the policy interest rate to 6-7%, which will reduce the allocation of public funds for interest payments by about Rs1 trillion”. He further requests that the central bank impose capital control to mitigate potential withdrawals of Foreign Institutional Investors portfolio investments.
Ironically many corporations that are currently demanding the lowering of interest rates are also likely to hold back investments given the uncertainty of the monetary policy
The petitioner is a regular guest on television shows where anchors give him free rein to express his views on economic policies without ever drilling down to the derivative consequences of his proposals. Given his latest petition with the Supreme Court of Pakistan, it might be useful to examine his proposal closely.
To begin with, it is important to accept that commercial banks, like all other rational investors, look at real returns rather than simply focusing on nominal rates. With SBP forward expectations of inflation at around 12.5-13% and policy rate at 13.25%, real interest rate is positive but less than 1%.
If policy rates were reduced to 6% as proposed by Dr Zubair in his Supreme Court petition, the central bank would be providing a negative 6% rate of return. As banks margins get squeezed due to such a negative return, bank profitability would also be severely dented. Far from spurring on additional lending, banks would be forced to rein-in credit and refuse deposits in order to shrink their balance sheets in an attempt to preserve capital.
As banks withdraw from the lending business economic growth will suffer. Ironically many corporations that are currently demanding lowering of interest rates are also likely to hold back investments given the uncertainty of the monetary policy. Moreover, negative real rates are likely to further exacerbate inflationary pressures.
Loose monetary policy pushes up consumption and thereby consumer prices. Also, it’s likely to push up values of financial assets and high-end luxury goods as well as create property bubbles. Asset bubbles and consumption-led demand may help certain businesses but would result in persistence of inflation, destruction of savings, and tepid long-term growth.
If foreign portfolio money were to suddenly exist, the Pakistan Rupee is likely to a further round of depreciation. This will almost certainly be followed by inflation going up further
Moreover, increased domestic consumption will result in a current account deficit, which the government has worked hard to curb, to once again burgeon to unsustainable levels. This will put pressure on the exchange rate. With rupee depreciating, reserves falling, and potentially capital controls in place, Pakistan is not only likely to see all foreign investment into the country stop, but potentially overseas Pakistanis inward remittances also decline.
Should the country go down that route it would soon find itself self-inflicting an economic crisis. Just when the country needs to further integrate the economy with rest of the world and participate in global value chains, artificially low-interest rates and capital controls will force the nation towards being an autarky with all that entails.
Few things could be more dangerous than having negative interest rates in a high inflation environment that presently exists in Pakistan. It is also worth asking the petitioner the rationale for choosing 6% as the base rate. Given that the petitioner wishes SBP to abandon its effort at curbing inflation why not suggest a zero-interest rate policy (ZIRP). Also, the petition states in one place that interest rate have little to no effect on private sector borrowing, but in another part of the petition submits that businesses, especially large scale manufacturing, are contracting due to the rate hike. This submission appears to lack consistency as it cannot be both ways.
While not wishing to sound alarmist, should the Supreme Court take up the case, international investors may want to withdraw their investment given the potential of imposition of capital controls as proposed in the petition. If foreign portfolio money were to suddenly exit, the Pakistan Rupee is likely to go through a further round of depreciation. This will almost certainly be followed by inflation going up further. This is like to push up interest rates.
Finally, it is worth reflecting on what would be the long-term consequences on the independence of SBP if the judiciary chooses to intervene in setting the monetary policy of the country.
postscript: I am also thinking of filing a petition to SCP. It will be that all airplanes should fly below national speed limits. 70mph is fast enough & important for safety as speed is major reason in the majority of traffic accidents. It will also allow planes to take off & land on normal roads helping businesses far away from airports.
Javed Hassan worked as an investment banker who has worked in London, Hong Kong, and Karachi. He tweets as @javedhassan. The views expressed in this article are the author’s own and do not necessarily reflect the editorial policy of Global Village Space.