Policy rate cut: pitfalls of policy advice

Following a cut in the policy rate by 0.5 percent on 15th December, 2014 and 1.0 percent on 24th January, 2015, State Bank has again decided to soften its monetary stance by reducing the rate by another 50 basis points to 8.0 percent per annum with effect from 24th March, 2015. In its Monetary Policy Statement (MPS) released after the Central Board meeting on 21st March, easing of monetary stance has been justified by a number of factors, which “have moved in a favourable direction”. CPI inflation remains on a downward trajectory and is expected to be well below the annual target of 8.0 percent in FY15. GDP growth was on course to surpass the FY14 outcome. External sector outlook continues to improve due to recent foreign exchange inflows and lower international oil prices. The government’s efforts to contain fiscal deficit was on track during the first half of FY15 despite slightly lower growth in revenue collection. “The current macroeconomic stabilisation has thus opened a window of opportunity to gear up reforms to ensure improvements in the economy that are sustainable”.

Giving a rather detailed picture of these positive developments, the State Bank has stressed that moderation in inflation was broad-based with food and non-food inflation receding and both the measures of core inflation, non-food, non-energy and trim – mean recording declines. GDP growth was expected to be higher than that of FY14 because LSM was likely to gain a traction due to a decline in the policy rate and lower prices of raw materials. Improved output in major Kharif crops and incentives in place, along with favourable weather conditions for Rabi season, were also expected to accelerate growth. With strong workers’ remittances, the current account deficit had also shrunk during July-February, 2015. External sector outlook remains stable due to lower price impact in imports and multilateral inflows. This was visible in the stability of foreign exchange market and a boost in foreign exchange reserves. The year-on-year growth in broad money (M2) was 11.5 percent, lower than the average growth of 13.6 percent in the last five years. This deceleration was largely due to contraction in Net Domestic Assets (NDA) of the banking system. Growth in credit to the private sector had remained subdued at Rs 158.9 billion during July-February 2015 compared to Rs 298.3 billion in the same period of last year. Monetary indicators largely reflected the underlying trends in falling inflation.

The case for slashing the discount rate, on the face of it, would appear to be well grounded and fully justified. It may be mentioned that this was the third consecutive policy rate cut since November last year and the reasons advanced by the State Bank for softening its monetary stance during the recent past are not different from those advanced by other central banks. As highlighted in the MPS, there is a visible improvement in the economy. CPI inflation is declining and is estimated to be in the range of 4-5 percent or considerably below the target of 8.0 percent for FY15, external sector outlook is stable, foreign exchange reserves are increasing, rupee rate in the exchange market is stable, M2 has increased at a slower pace and credit to the private sector needs to be expanded. In a situation like this, there are, of course, compelling reasons to reduce the policy rate. In fact, businesspeople and industrialists, in general, would feel somewhat disappointed because they were expecting and pleading for a higher rate cut to reduce their cost of production enabling them to be more competitive in the international market.

However, while a reduction in policy rate by 0.50 percent is, in our view, the right decision, the State Bank seems to have overplayed its hand in highlighting the positives of the economy, without mentioning its vulnerabilities. At no place in the MPS, has the SBP made an effort to stress the point that the country is still facing risks that need to be addressed for a sustainable improvement in various areas of the economy. In fact, the State Bank seems to have deliberately avoided to stress the difficulties and challenges likely to be faced in maintaining the present favourable trends. For instance, inflationary pressures in the economy could re-emerge if there is an increase in oil prices, gas prices go up as agreed with the Fund, perishable food items do not remain in abundance due to inclement weather and global commodity prices move upwards. The trend in all these favourable factors could change at short notice and reignite price pressures. Besides, an increase of 11.5 percent in M2 till February, 2015 as against an average of 13.6 percent in the last five years (a strange comparison) and a rise in aggregate demand as envisaged by the SBP could have inflationary repercussions in not-too-distant future. Also, an improvement in the external sector and fiscal accounts is largely due to certain one-off or transitory factors like the receipts from Sukuk, CSF and a generous grant of dollar 1.5 billion from a friendly country. Such receipts increase the debt of the country and must not be relied upon to paint a positive picture of the external sector. On the other hand, the most worrying aspect is that the government is unable to restructure the economy or make some fundamental reforms to increase the tax-to-GDP ratio and narrow down the trade deficit. Tax net has not been widened despite some efforts by the FBR, refund claims continue to be delayed to depict a better picture of the fiscal account and deficit on merchandise account continues to widen due to rising imports and falling exports. In certain cases, the government is doing quite the opposite to the well-known policy prescriptions to reverse a bad situation. For instance, the country’s trade deficit could have been improved by depreciating the Pak rupee but the Finance Minister is reported to be quite averse to such a shift in policy. The SBP has even gone to the extent of comparing the growth rate to the previous year’s and refrained completely from mentioning the target of the current fiscal, which would have shown a somewhat negative picture of the economy. As is well known, State Bank has always been famous for its objective analysis of the economy and is very well regarded domestically and internationally for this uncommon quality of economic assessment. It will be a great service to the country and its people if it maintains its autonomy and professionalism in the true sense of the word and does not play a second fiddle to the government to preserve and protect its hard-earned status and prestige.

Overall, a cut in the policy rate by as much as 2 percentage points in a short span of four months is expected to increase the demand for private sector credit, reduce unemployment, and revive growth. Nonetheless, such an outcome is only possible if there is improvement in physical infrastructure including energy supply, governance and delivery of services. Also, authorities would need to maintain a competitive exchange rate and shift away banks’ financial resources from investment in government securities for utilisation in the private sector by reducing fiscal deficit. The reduction in interest rate on rupee deposits by such a high margin could also promote dollarisation of the economy because of a lower differential between rupee- and dollar -denominated assets. Besides, the rate of return on Behbood certificates and pensioners’ accounts would decline, affecting the quality of life of old people who rely mainly on the income that they derive from these schemes for their sustenance and cannot earn any more. Such disadvantaged groups of society need to be protected because, unlike the past, their offsprings are generally not prepared or cannot afford to carry their burden. The Edhi homes and other social service groups have only limited capacity to cater to their needs. A way has to be found to preserve the self-respect of golden agers.