April 19, 2023
ISLAMABAD – THE State Bank of Pakistan is trying to check inflation through just one instrument, the interest rate, based on the theological belief that the issue is demand, ignoring other, more critical factors fuelling inflation today.
There are both demand pull and cost-push factors influencing inflation, and this instrument is being expected to achieve multiple objectives.
The sources of demand in the economy are households, the corporate sector and government, who in turn receive money from different sources. The role of each source and what can be done about it is somewhat limited, especially because the acts of one can nullify the actions of others, at times as a result of unanticipated developments.
For example, when the SBP increases the interest rate it expects a change in behaviour of the borrower. However, if the largest borrower, the government, whose imprudent and reckless fiscal behaviour has worsened the precariousness of our situation, simply continues borrowing to finance expenditures which (except on development projects) are politically inelastic in the short to medium term and are more than its revenues, it negates the objective of raising the interest rate.
SBP’s strategy to fight inflation by consistently raising interest rate seems to be flawed
Net borrowing cost
And the possibility of a change in behaviour is further diluted, if not rendered irrelevant, if the net cost of borrowing is a mere 50 to 60 basis points because of the Rs 6 trillion injections by the SBP (lending to commercial banks which they then on-lend to the federal government).
Then there are inflows of remittances and donor financial assistance which create a demand for goods and services that render policy instruments for containing demand largely redundant. For example, annual remittances of close to Rs14 trillion — 20 per cent of GDP (both through the formal financial sector and through informal channels — moneychangers and migrants bringing cash on home visits), generate a demand for goods and services.
And these demands are more or less impervious to interest rates, partly because the recipients are less affluent households, dependent on these flows for meeting their regular basic consumption needs.
Credit schemes
Again, SBP’s own sponsored export finance and long-term directed credit schemes (the more recent one being the TERF) at highly concessional rates of interest (although the rates for some schemes are now being revised) ‘‘create money’’, diluting the influence of its monetary policy instruments to control inflation.
And then, not to forget, we have a significantly large informal sector that conducts transactions mostly in cash (currency in circulation is presently in excess of Rs.8.5 trillion (more than 12.5 per cent of GDP), on which adjustments in interest rates would have a limited impact.
Furthermore, the effectiveness of SBP’s policy to ‘target’ some rate/range of inflation is constrained by the structural nature of the problems.
This monetary policy instrument has its limitations. For example, an increase in the interest rate cannot fight imported or food inflation when the latter is high because a) the support price of wheat is above its international price; b) increases in price of energy and oil raise the cost of farming, processing and transportation; c) yields per acre of crops continue to be low; and d) of hoarding, and cartelisation.
Cost-push factors
Similarly, there are cost-push factors affecting large areas of the economy resulting from:
• Rigidities in prices administered by government (e.g. of electricity, gas, petroleum products, etc.) _ which have been revised sharply in recent weeks;
• Continuing supply chain issues driven more by the somewhat arbitrary import restrictions imposed by the SBP and price rigidities (despite the easing of supply disruptions post pandemic), creating opportunities for profiteering;
• A convoluted and badly designed tax structure that is heavily dependent on high rates of GST and other indirect taxes as revenue collecting instruments and mechanisms;
• d) heightened inflationary expectations owing to eroding business confidence because of continuing political instability, policy confusion and concerns pertaining to restoration of the IMF programme;
• significant volumes of informal trade/smuggling under the active patronage of state functionaries;
• A host of powerful organised cartels manipulating prices- like those of sugar, vegetable oil, wheat, fertiliser and cement manufacturers;
• poor economic governance adding to costs; and
• continuing poor productivity (failure to get higher output from existing resources) and government investments in unproductive schemes or projects that have stalled.
Increasing interest rates is not the remedy for revisions in government-administered prices (unless the inflation target is adjusted for the effect of these prices) or inflation fed by rupee depreciation and rising food prices. And these prices are not affected by the weakening in demand for goods and services and the profligacy of government that keeps level of budget deficits high _ whose financing raises the interest rate on borrowings.
No funds for private sector
This worsens the situation, impairing the manufacturing sector, by crowding out the private sector seeking funds for even working capital, let alone for investment.
In fact, this heavy reliance on high interest rates is merely protecting the incomes of banks and creditors from the injuries of inflation being suffered by the general populace.
Furthermore, as implied above, simply pursuing singlemindedly the goal of checking inflation through the instrument of interest rate adversely impacts growth and employment creation.
By employing such a strategy, the SBP is left without an adequate set of policy instruments in its armour to stimulate growth, lower the rate of inflation and ensure stability of the exchange rate, all at the same time. Lest we forget, inflation targeting has not been adopted as the sole objective by all central banks. The central banks of two economic powerhouses, China and USA, do not merely target inflation _ both inflation and employment are an integral part of their mandates.
And, in any case, the stubbornness of a high rate of inflation in a relatively depressed economy translating into a wage-price spiral would be remote if the rate of economic growth is lower than the rate of increase in the labour force.
Although a variety of import-curbing policies and instruments have been adopted, the rupee is supposedly ‘free floating’ when it comes to trade in goods and services as well as on the ‘capital account’ (although ostensibly only for non-residents).
Capital inflows
This means that we need capital inflows and donor support to maintain foreign exchange reserves in tradable currencies to enable us to face any crisis in financing external obligations.
And any restriction on bringing in, and repatriating, capital will make external investors reluctant to bring in this money.
But then reliance on inflows of borrowed capital on a continuing basis is clearly not sustainable, as we found out to our cost when we incentivised short-term foreign portfolio investments in the government’s debt instruments by jacking up interest rates.
This strategy, apart from temporarily appreciating the exchange rate, worsened the adverse movement in the domestic business cycle by discouraging domestic investment. This “hot money” beat a hasty retreat at the first sign of weakness, feeding the already stressed conditions with respect to external payments.
Solvency issue
Despite the fragile economic environment, we have opted for further raising the interest rate, partly to again solicit short-term external capital inflows for managing the external crises. This intervention is more than likely to fail because we are confronted with a solvency issue and not a financing/liquidity issue.
More borrowings to raise foreign exchange reserves, to discharge existing debt obligations and to finance our trade deficits will merely lead to a higher level, and more difficult to service debt, in an economy that is fast shutting down.
Therefore, under the above argued circumstances and identified factors, high and floating interest rates are the wrong instrument.
So, in the light of the discussion above, what are the options available in the short to medium term to wrestle with the ravages of inflation?
• It has been shown that several factors make inflation handling difficult. For instance, addressing food inflation requires a comprehensive policy package comprising policies that a) incentivise change in cropping patterns and increase in yields and cost efficiencies in production processes (a medium term strategy);
BUT b) in the near term the first best choice is to open up trade with our neighbours; thereby also collaring the issue of informal trade/smuggling; and supplement this policy action by i) withdrawing import duties on solar tube-wells;
ii) lowering the duties and petroleum levy on high speed diesel while raising these charges on petrol by the same amount; and ii) as argued below, forcing fertiliser manufacturers to reduce the price of urea.
• Counter price gouging by cartels by not just opening up trade but also drastically reducing, if not eliminating, import taxes, thereby forcing cartel formulators to change behaviour.
Big profit margins
Just as illustrations, take the cases of the cement and fertiliser industries.
The cement industry is operating 60 per cent below its capacity and selling cement at a margin of 26 per cent (because of the eligible depreciation allowances for tax purposes and the cartel enabling it to raise prices whenever there is a pressure on costs).
Similarly, the fertiliser industry, thanks to a huge gas subsidy, is earning a gross margin of more than 35 per cent with a net profit margin of more than 23 per cent _ compared with Apple’s 22 per cent, with its market power, productivity and efficiency!
With these levels of returns, essentially because of subsidies, the domestic price of fertiliser should be subjected to further, more effective, controls by a more vigilant government or the Competition Commission;
• check government expenditures by a) starting to shrink the size of the federal government by reducing the number of divisions to one-third (placing personnel in a surplus pool, thus saving on rents, utilities, cars, etc,) and banning all new recruitments, purchase of motor cars and new development schemes; b) reviewing the PSDP to identify low-priority projects or those on which less than 20 per cent expenditure has been incurred and intra-provincial projects should be transferred to the respective province for them to decide their adoption;
• employ a combination of increased loadshedding and early closure of commercial centres;
• the short-term solution of enhancing the scale of programmes like BISP and Ehsaas, to provide some relief to those in extreme pain hovering below or on the poverty line, although required, is clearly not sustainable.
They cannot be an alternative and replacement of a more comprehensive and self-sustaining growth process;
• lower the interest rate (making the real rate negative), bringing it well below the core inflation rate _ there may even be a need for a two-year suspension on the servicing of both government and private sector debt;
• the continued servicing of the existing IPP contracts is unsustainable. They need to be renegotiated speedily (rates of return, capacity charges and currency).
And these efforts need to be complemented by adequate and timely investments to attend to the technical inefficiencies and governance issues of the transmission and distribution systems; and
• finally, but more importantly, defuse the debilitating effect of political and economic instability by holding early elections to place in office a government with the legitimacy to launch, and implement, such actions.
The writer is a former governor of the State Bank of Pakistan
Published in Dawn, April 17th, 2023