January 22, 2011

The State Bank’s decision to increase the discount rate seems justified to counter the rising inflation, a negative real interest rate and increased government borrowing.

When real interest rates are negative, there is no incentive for lending and saving. In such an inflationary environment, every individual would rationally spend her money today rather than save for tomorrow. This would further deepen the inflationary spiral.

By Ali Salman

Business leaders representing chambers of commerce and trade associations across the country have opposed the consecutive hike in the policy discount rate, which now stands at 14.5%. Arguing that such hike will increase the cost of borrowing, the business community has expressed their concerns over the implications of this rise on the cost of doing business. Writing recently in The News, notable economist and formerly head of debt reduction office of the federal government, Dr. Ashfaque Hasan Khan has opposed the monetary policy rise arguing that the source of current inflation is largely price surge in the food items due to their shortage. For Hasan, this inflation cannot be tackled by macro economic measures such as monetary policy.

If I were a member of the Monetary Policy Committee set up by the new Governor, I would have voted in favor of the discount rate raise. The State Bank’s decision to increase the discount rate seems justified on the face of a rising inflation, a negative real interest rate, and increasing government borrowing.

The argument that current inflation is not a monetary phenomenon rather but is rather driven by food shortages seems to loose ground as the Economic Coordination Committee has allowed a long outstanding request of the Punjab government to export surplus wheat stocks. The wheat is the single most important factor in the Sensitive Price Index and carries 16% weight. If the inflation was really driven by food shortages, then how can we explain excessive surplus stock of wheat?

There is a very popular myth that low interest rates induce enterprises to take loans and make productive investments that in turn drive economic growth. That is actually rooted in the idea of business cycle originally theorized by Keynes. There is another adjoining myth that economists refer as Philip’s Curve which presents a so called trade-off between inflation and growth rate. Without going into details in this article, I would argue that popular demands to lower interest rate stems from above two economic theories. History has refuted both.

Writing for Economic Affairs, Eamonn Butler, Co-founder and Director of Director of the London-based Adam Smith Institute has argued that low interest rate cause artificial re allocation of capital, and also induce cheap credits, which then induces investors to deal in speculative businesses. According to Butler, the low interest rate leads to an increase in the demand for both investment and consumption goods which causes rise in inflation.

In fact, the Butler argument gainfully explains the rise and fall of Pakistan’s economy during last 10 years. A 100 percent reduction in the discount rate from around 14% in 2000 to 7% in 2003 resulted in excess liquidity. In the absence of a sound productive sector, this was used by investors in speculative businesses like real estate and stock. In around 2007-08, this asset bubble had already begun to burst. It started from a spike in inflation from 3% to 12% in couple of years, which again touched the high rate of 25% in 2008-09, thanks also to the international oil prices. Real estate and stock markets collapsed like house of cards evaporating savings from the economy. This ultimately forced the newly elected government to rely on successively increased borrowing from banks and ultimately from IMF again. While the asset bubble burst, the discount rate remained largely stable thus only causing the inflation to rise further while eroding purchasing power of masses.

Judging from this very recent history, the active stance of monetary policy seems right on the spot.

The claim of business leaders about the impact of increased discount rate on the cost of borrowing is arithmetically correct. Naturally it jacks up the cost of capital. But at the same time, a high interest rate also induces the households and business firms to park their savings in the banks. This inducement actually curtails down the inflationary expectations. Think about millions of pensioners and widows who depend upon the monthly return from banks for their livelihoods and not just about the business houses. Capitalism is not just for capitalists.

As a matter of fact, even now the real interest rate in Pakistan is effectively negative with the discount rate still trailing the inflation rate. When real interest rates are negative, there is no incentive for lending and saving. In such an inflationary environment, every individual would rationally spend her money today rather than save for tomorrow. This would further deepen the inflationary spiral. Thus effective utilization of monetary policy instrument to check the inflation rate in the right time is extremely important. The stance of the State Bank is vindicated.

Having said that, it is unreasonable to rely only the monetary measures for macro economic management. The finance ministry must be held responsible for increased level of borrowings, whether for budgetary or commodity operations. According to the State Bank, this excessive borrowing has also contributed towards inflation due to an expanded circulation of money. The government must strictly adhere to the Fiscal Responsibility Act and should contain its fiscal expansion. Similarly, reliance on open market for commodity operations rather than controlling them through the inept state institutions such as Trading Corporation of Pakistan should relieve some of the fiscal burden which the populist government has taken on itself.