Monetary Policy: likely impact on inflation and interest rate

In the last Monetary Policy decision, discount rate has been maintained at 10 percent against expectations that interest rate will reduce at the back of reduction in CPI, average CPI recorded at 8.6 percent in FY14. With declining trend of inflation and projections of SBP for single digit inflation, discount rate is expected to reduce further. For FY15, CPI is expected to remain between 7.5 percent and 8.5 percent. These estimates are based on reduction in government borrowing, moderate aggregate demand and stability in commodity prices. Other factors that could affect inflation is the utility expense. CPI against food groups increased from 7.1 percent in FY13 to 8.6 percent in FY14 whereas NFNE actually declined from 9.6 percent in FY13 to 8.3 percent in FY14. This shows that factors which accounts for food inflation is the core factor, which likely will increase inflation. The international oil prices continue to be volatile and not expected to reduce below US dollar 100 per barrel since high oil prices translates into higher GDP of OPEC. If oil prices decrease, it is unlikely the government will pass on these affects to the people as seen in the past. Revaluation witnessed recently too has not made an impact on the price of fuel. Price in Pakistan therefore is based on politics rather than economics or any market-based dynamics. A source for liquidity pressures in the economy is sluggish economic growth and foreign direct investments. GDP growth target for FY15 has been reduced to 4.9 percent, which was 5.8 percent in FY14. SBP stressed that the government must devise fiscal and energy sector reforms and plan foreign financial inflows to mitigate uncertainty and pressure on reserves.

With reduction in discount rate reducing the benchmark rate, private sector credit growth increased from negative 0.6 percent to 11.4 percent. Minimum rate on deposits has increased from 6.5 percent to 7 percent. If returns on fixed income increase, banks would continue to prefer financing the fiscal deficit through investment in fixed income securities rather than focus more on taking risk and extend private sector credit, which declines investment to GDP ratio. Despite reduction in rates, banks are not actively advertising their products and still find comfort in risk free money market investments yielding a return of 9.8 to 9.99 percent approximately. With respect to macro indicators, total assets of banks increased from Rs10,537 billion in CY13 to Rs10,752 billion in March-14. Deposits reduced from Rs8,318 billion as on CY13 to Rs8,151 billion in March-14. Profit after tax for the banking sector was Rs111 billion in CY13 and Rs33 billion in March-14, which at the same run rate will be higher than previous year on consolidated basis. Advances reduced from Rs4,047 billion in CY13 to Rs4,014 billion in March-14.
The competition in the banking sector is intense with smaller and midsized banks pushing to pull deposit from larger banks offering competitive and attractive rate on liability products. SBP time and again has encouraged banks to provide a healthy return to its depositors whereas banks strive to lower the rate of return, which in turn increases the banking spread to improve profitability. Since the return on deposits is a cost to the bank, in an ideal situation, no bank would like to incur this cost to squeeze its spread.

Due to low returns, depositors find alternate mediums for investment by depositing funds with National Saving Schemes (NSS), Mutual Funds and Stocks.

In order to help counter inflation and assist the depositors with a healthy return, SBP has been encouraging depositors to put their savings in government securities through Investor’s Portfolio Securities (IPS) accounts. State Bank of Pakistan (SBP) has introduced a minimum 7 percent floor on all categories of Savings/PLS Saving products. The saving deposits of banks account for 38 percent of all bank deposits and 52 percent of total number of deposit accounts. As per SBP expectations, if depositors shift their savings from banking to alternate modes as discussed above, the market forces will induce banks to increase their deposit base. The people who would be impacted the most are those who have low savings, are retirees and need an additional source of revenue through high rate of return. Keeping with the stance to assist small savers, SBP increased the minimum return on Saving/PLS Saving products.

The challenge for SBP with the Monetary Policy is to reduce inflation and encourage private sector lending alongside an attractive rate of return for depositors to counter rise in inflation. The Monetary Policy cannot work in isolation considering external shocks e.g. international oil prices, recessionary impact, devaluation in interest rates or government borrowings. Pakistan is a net importer therefore any devaluation in the exchange rate against the dollar will make imports expensive and put further pressure on the reserves. An encouraging sign for the economy are worker remittance, which average more than $1 billion each month. Foreign investors take a strict view on Pakistan keeping into account the country risk, therefore, if domestic investors are hesitant with investments, it is unlikely that foreign investments would flow.

In order to curtail inflation and finance government budgetary deficits, SBP’s decision on the Monetary Policy alone cannot work in isolation unless such policies work hand in hand with fiscal decisions to increase tax base and eliminate transactions, which run parallel to the economy. The government’s total expenditure to GDP is 19 percent whereas revenue to GDP is 12.5 percent creating a mismatch, which needs to be filled through tax base rather than borrowing from the banking sector. Though decisions to maneuver the economy also rests in the hand of the government, what will eventually help resolve the situation is high degree of integrity and accountability for public service across the board to address every issue faced by the people in the economy to better their lives.