The Interest Rate Conundrum! | Dr Kamal Monnoo

To spur investment and economic growth, the State Bank of Pakistan (SBP) dropped interest rate on September 12, 2015, by 50 basis points (0.50%), bringing it down to now 6%. In essence a good move, as the arising risk to banking spreads (from lower lending rates) comes at a time when inflation is at a historic low in over 30 years and likely to stay that way – at least in the near-term – due to an increasingly bearish outlook on the global oil and commodity prices. However, in doing so, the risk SBP does assume is that unless in the coming days it is very vigilant and pro-active in its oversight cum management of the national financial institutions, the slightly weaker or smaller banks of the country will suddenly become quite vulnerable; either to closures or acquisitions by the bigger banks. If this begins to happen then this in itself would be an undesirable outcome because it can in-turn lead to three things: First, we may witness further exiting of the foreign banks from the Pakistani banking sector – most western banks (Citi, BOA, HSBC, Barclays, etc) have already departed citing high risk and low returns. Second, new/revised capital standards will become necessary in an already difficult period for the small banks, thereby creating further uncertainty and financial instability for these smaller banks, and most important, third, with large banks becoming larger, competition per se will decline in the financial markets raising renewed concerns on anti-trust and predatory lending to the private sector consumers. And all this, as we know, can end up defeating the original purpose of promoting investment and economic growth!

Setting of interest rates in any economy entails hard choices which are naturally preceded by the overall vision policymakers hold for an economy and by market projections that are carefully crafted by their team, using hard core market data. The broad decision being about the preference of the policymakers: on whether to reinforce safety or to reintroduce risk in the financial system. For example, after the faith in the U.S. financial system had been broken owing to a string of bank runs and failures during the Great Depression, the United States started insuring customer deposits to re-instill this lost faith. However, in deep contrast China today wants to do the opposite by introducing deposit insurance obligations to be assumed by the Chinese banks. In doing so, Beijing instead is looking to shake the public’s faith, namely the long held belief that the government will bail out troubled banks. As the present Chinese leadership moves to restructure its state-run economy, such banking reform is considered critical. To help bolster consumer demand in the country and wean itself off growth fueled by cheap credit, China needs its banks to take a more market-driven approach. Meaning: to make smarter loans to companies and individuals, and to accept the consequences when they don’t work out.

Similarly, our policymakers also will have to grapple with the prevailing ground realities and the specific banking requirements pertaining to the Pakistani economy. If we look at the lending portfolio of the Pakistani Banks in the last 3 years, the numbers present a very bleak picture where bulk (nearly 75-80%) of the lending by the domestic banks is being done to the government itself. So, basically the biggest beneficiary in effect of this reduced rate will be the government itself, and this reality in itself is quite unhealthy for the prospects of meaningful investment and growth in an economy due to a number of reasons:

1) As the banking spread comes under pressure the obvious inclination on their part would be to further increase their lending portfolio to the state, especially when the Pak government is also borrowing at market rates, meaning, at the same rate as the private sector – ‘Sovereign Lending’, as we know, is considered risk free and in most developed countries done at close to a ‘nil’ lending rate. And such a development will also mean that the private sector in the process will get further ‘crowded out’.

2) The private sector is always a more efficient user of capital than the state. By diverting the bulk of capital to the public sector domain we will not only be settling for a less return on our capital and investments, but will also be affecting out national competitiveness. A fact, which is already beginning to show up in our falling exports.

3) Though lending rate and investment do have a proven correlation in mature economies, here in Pakistan a mere rate reduction will not automatically translate into an enhanced investment level. Pakistani financial environment is already a victim of a predatory lending culture owing to: an absence of chapter-11/bankruptcy laws, borrowing preconditions still largely continuing from the 70s period when the rules heavily tilted in favour of the state lender, and last but least, an obsolete view on tangible securities and personal guarantees held deer on lending pre-requisites by nearly all the banks in Pakistan, which not only shifts the risk entirely on the borrower, but also makes it virtually impossible for start-ups, and small and medium sector enterprises (SME) to obtain loans. Innovations need entrepreneurial start-ups and SME, as we know, is always the real engine of equitable growth and job creation in any economy, e.g.: Germany’s Middle stats.

Not taking any credit away from our economic policymakers from their bold and a courageous move of reducing the interest rate to an indeed very interesting level of 6%, they would be well advised to stop here for now and instead reflect on how to optimise results of this initiative, because the rate reduction itself was perhaps the easier part. The real challenges now lie ahead where they need to ensure that the bringing down of the interest rate also in-turn tangibly translates to sustainable and productive investment and that too in a manner which is inclusive, equitable, and allocates capital and resources to the most efficient users.


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