Low interest rates: catalyst for expansion

Pakistan’s economy is currently facing three broad challenges in the shape of persistent inflation, eclipsed private investment leading to low growth and continuously rocketing total debt due to a low tax to GDP ratio.
The resignation of two central bank governors and one finance minister in Pakistan since the start of 2010 has exposed a breakdown in policymaking, undermining efforts to revive growth amid surging prices and terrorism. Lack of continuity at top finance seats indicates the misalignments between the economic and political integration of the system. Shahid Kardar’s resignation is attributed to differences over the bank’s autonomy. The analysts say that successive loss of key economic managers may undermine the credibility of Prime Minister Yousuf Raza Gilani’s government as it seeks aid resumption from the International Monetary Fund to ensure its survival. The refusal to extend Benazir Income Support Program (BISP) led to the departure of the Governor who wished to rationalize the spending. Increased government borrowing triggering a further inflation amid challenging economic conditions is also dubbed as the reason behind the quitting of the governor.
With all these things in mind, the State Bank of Pakistan’s unexpected drop of 50 base points in its discount rate to 13.50 per cent from 14.00 per cent is intriguing. SBP sources say that the key parameter in this assessment is the outlook of inflation that indicates that average inflation in FY12 is expected to remain in line with the announced target. The bank authorities are convinced that no adjustment in the interest rate would have entailed further tightening of monetary policy in real terms, which is not warranted given the decline in private investment.
Pakistan’s central bank last held its discount rate unchanged at 14 per cent during its May meeting. Pakistan reported annual inflation of 13.92 per cent in June this year, up from 13.23 per cent in May, and 13.04 per cent in April, the Bank had previously commented that “the average CPI inflation for FY11 is likely to remain between 14 and 14.5 per cent, which is lower than the central bank’s earlier projections”. The Pakistani government announced an inflation target of 12 per cent for FY 2012, with a desired path for inflation of 9.5 per cent and eight per cent in the subsequent 2 years.
But the million dollar question is that whether a mere decrease of 50 base points will help decrease inflation or not. The answer again is a desperate need to make drastic cuts on government borrowing that has registered a 58 percent increase over a period of one year.
The business community has termed it as a cosmetic decision that is unlikely to bring any fundamental change on the economic landscape of the country. Structural changes are required to have a comprehensive annual growth of national economy which grew at a rate of 2.5 per cent which is less than the annual population growth rate.
For ordinary consumers the rate cut will not bring any immediate good news. It is because the consumers aren’t exactly the main focus for emergency rate cuts, which are designed to stimulate the economy and encourage large businesses to spend more. But they do reap the rewards in the long run.
Overall, the effect of an interest rate cut is the psychological effect it has on investors and consumers; they see it as a benefit to personal and corporate borrowing, which in turn leads to greater profits and an expanding economy.
A decrease in interest rates means that those people who want to borrow money enjoy an interest rate cut. But this also means that those who are lending money, or buying securities such as bonds, have a decreased opportunity to make income from interest. If we assume investors are rational, a decrease in interest rates will prompt investors to move money away from the bond market to the equity market. At the same time, businesses will enjoy the ability to finance expansion at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices. Investors and economists alike view lower interest rates as catalysts for expansion.
The writer is a freelance contributor