Monetary policy and rationale for a rate cut

It is probably a time of great excitement for the monetary policy department (MPD) at the SBP. For those who stand outside the gates are placing their bets on a lower, actually a much lower policy rate. And on what grounds? Objectivity may once again scoff and dismiss; the horse rides on dark blue clouds not knowing that it will rain soon.
A recap of events is imperative; after a resignation by the esteemed ex-governor, many lost hope as in the heart of hearts, as most knew of the reason why he had taken the leap. And voila! Not long after the economy saw a discount rate cut! The reasons cited signaled a change of stance at the MPD; an emphasis on dismal private investment or gross fixed capital formation levels, which in fact were the lowest since FY-74, in addition to the much laudable conformation of the government to the prescribed borrowing limit of Rs1,290 billion from the SBP.
Is lower GoP borrowing from the SBP an indicator of fiscal discipline?: In theory, government borrowing from the central bank spurs inflation as the latter resorts to monetisation of debt, or in simpler words, printing of money that causes monetary slippages leading to higher prices. Given that the central bank has two primary and contradictory objectives; encouraging growth and containing inflation, the latter enters into stress given excessive borrowing by the government.
In the case of Pakistan, the history of over borrowing by the government dates back to the wheat, oil and exchange rate crisis of 2008. Since then, although all three variables have undergone significant adjustments in pricing, formulas and degree of government control, public borrowing caused by fiscal slippages continues unabated at worrying levels.
Perturbing as they may have been for spiraling inflation, coupled with a wave of uncertainty at the global and politically jinxed domestic level, the private sector stands the most harmed as growth and investment have remained stalled in the last three to four years. However, much to its dismay, very little has been done to allay its predicament. The accompanying graph shows strong correlation between the performance of GDP, large scale manufacturing (LSM) growth, and private sector credit growth. It can be clearly seen that as the focus has shifted from promoting the private sector, LSM and subsequently the GDP growth. In the golden years when GDP growth was above five per cent, growth in private sector credit stood at more than 15 per cent.
Complex realm: But keeping this perspective aside for now and entering the ‘complex realm’ of policy making at the SBP, some more indulgence in government borrowing would be imperative. Reinstating, the rationale in policy decisions in FY11 rested on three main factors (i) public credit (ii) inflation, (iii) favourable external/current account position.
Suited to its stance of increasing the policy rate to in theory “curb” public demands on SBP’s treasury, the decision to “maintain” was fair to say the least when the government exercised some discipline by conforming to the prescribed limit of Rs1,290 billion. However, the July 12 decision heavily reeked of political ‘interference’ especially when stagnancy of the fixed capital formation was stated as one of the key determinants.
It is common knowledge that private borrowers who wish to inject capital in businesses borrow from commercial/ scheduled banks (ScBs) and not from the central bank, as the latter only caters to banks and not the private sector. Thus, even if the government limits it borrowing from the SBP, higher borrowing from SCBs severely hinders the private sector’s ability to access any capital.
In fact, the graph shows that on a YoY basis, GoP borrowing from ScBs has grown by 106 per cent, that is, from Rs739b in Aug-11 to Rs1,524b in Aug-12. Thus, lowering the price to encourage more demand does not make sense when the supply of funds is rationed in favour of the government.
Synchronised movement: The price argument actually holds the government more than the private sector as the former’s cost of borrowing and thus its impact on the budget gets significantly neutralised in the wake of a discount rate cut, although the government has no legislative limit to the amount it can borrow from any source. Technically, as shown by the graph (yields and interest rates), the interest rates, that is, 6m-KIBOR (base cost of borrowing for the private sector) and discount rate and yields on T-Bills move in complete synchrony.
Thus, the decisive factor between lending to the public or the private sector is not the return but the risk that each behold. Stating the obvious, the government always stands triumphant as its instruments are considered to be risk free.
Moreover, the financial system cannot be blamed for their perception of high risk with respect to funding the private sector. The non performing loans to advances ratio, or the infection ratio has been on the rise since FY08. In fact, during the first three quarters of FY11, the infection ratio climbed to 14 per cent and above from the lows of 10-11 per cent in 1HFY08.
Thus, the first steps that need to be taken involve revoking the ovation that government has been receiving for keeping its borrowing in check during FY11 from the SBP only. On average, the government raised Rs920b every quarter in FY11 and almost Rs850b in 1QFY12. Since reining the government is out of the domain of the SBP, the ministry of finance should initiate reforms it wants the economy to experience real and sustainable growth in the upcoming years.
Are inflation levels laudatory?A highly rosy picture is being presented by the inflation figures which for the first time in almost two years have settled at 10.5 per cent in Aug-11. The reasons are twofold; a high base effect owing to floods at this time last year, and, second, a change in the base year (from 2000-01 to 2007-08). While the first is justifiably acceptable, the second may involve some level of contention as the average inflation rate went down from 13.9 per cent from less than 13.7 per cent in FY11 and weightages for certain goods have changed.
However, close inspection of recalculated inflation levels under the new base do not present a very different picture from those calculated under 2000-01 base. Broadly, it can be identified that months during which inflation peaked (<15 per cent), that is, from Sep-Dec FY11 still show YoY inflation at levels near to or greater than 15 per cent. However, the contention basically lies with viewing inflation from a yearly (YoY) perspective when the monetary policy decisions are being made on a bi-monthly basis. For instance, since Jul-FY12, inflation has increased by 1.8 per cent on a compound basis, while showing deceleration (at 10.5 per cent in Sep-11) on a YoY level. Understandably, the idea is to view the effectiveness of monetary policy with a one-year lag but immediate corrosion will be undervalued wrongly because of a one-off natural calamity last year which forms the comparative base for this ‘normal’ period. And what more would the policy authorities like more than an inflation level that conveniently falls under the FY12 inflation target of 12 per cent. Coming to the moral of the story, nothing has fundamentally changed in the economy for the SBP to announce a rate cut. But, the inevitable shall prevail and the rate cut will come! Establishing this assertion are the T-Bills rates cut by 32-47bps yesterday. What nice give-aways for the cheery government of ours!