Transcript effects of flactuating interest rates on the

EFFECTS OF FLACTUATING
INTEREST RATES ON THE
ECONOMY OF PAKISTAN
BILAL A. JUMANI - 6976
SAAD T. AWAN - 7147
INTRODUCTION
• Pakistan started facing a deep economic crisis
from the early months of 2008.
• When international food and energy prices
started to sky rocket, the balance of payments
position went awry, resulting in heavy
withdrawal of foreign exchange reserves and
sharp depreciation of the rupee value.
• The government resorted to the orthodox
method of tightening monetary policy and hence
the discount rate was raised to 13%.
• Even at this high rate the government was not
able to significantly curb inflation and that
coupled with sharply depleting foreign reserves.
• Government was left with no option but to reach
out to the IMF.
• Among the conditions to bailout money from
IMF, one was to immediately hike the discount
rate by a further 200 base points to 15 %.
• Needless to say the increase in the key policy
rate has had a severe effect on the domestic
economy.
PROBLEM
• This graph clearly shows that by October 2008
our foreign exchange reserves had reached a low
point, government borrowing from the SBP was
at an all time high and year on year inflation had
reached a staggering level.
• Apart from the mandatory requirement for
obtaining the IMF bailout money, the reasons
cited by the State Bank of Pakistan for hiking
discount rates were three
▫ Curb consumption to avoid second round of
inflation
▫ Improve real interest rates to encourage FDI and
strengthen the rupee
▫ Curb credit expansion
• The results achieved so far have been
unsatisfactory
▫ Core inflation stays stubborn at more than 18%.
▫ Consumption accounts for 80% of GDP
▫ Food imports is 10% of the import, shown a 68%
increase in the face of depreciating rupee, as food
has a 40% weight in CPI the increased imports
turns into inflation.
▫ Even at a discount rate of 15%, the real interest
rate remains significantly negative
▫ Credit expansion for seven months FY-09 is
10.4%(17.8% annualized for FY-09); though lower
than 28% in FY-08 is still higher than 16.4% in
FY-07.
▫ FDI in Pakistan has never been a function of
interest rates.
▫ Foreign investment is driven by the size and
growth of the market, consumption pattern and
stability. And unless stability comes back,
monetary tightening cannot help.
IMPACT OF DISCOUNT RATE HIKE ON
VARIOUS SECTORS OF THE ECONOMY
TEXTILE SECTOR
• Textile sector is the backbone of the country’s
export and mainstay of the economy.
• Out of the total annual export of $18 billion,
Textile sector contributes $10 billion that is 60%
of the total exports.
• Confronted with innumerable problems,
including high cost of production, energy
shortage, and high mark up.
• Due to variable mark up rates and slumping exports,
textile industry (consuming a fifth of bank credit)
has accumulated bad loans of over Rs320 billion.
• Beside the worsening energy shortages (raising
production costs), global recession (reducing
exports), and recent crash of the over- valued rupee,
is the fruit of lending on floating rates to borrowers
lacking financial literacy.
• Rising interest rates in Pakistan has put forward a
major problem for this sector as it will increase the
number of non performing loans and it will increase
the cost of production causing exporters losing
competitiveness in international market.
INSURANCE SECTOR
• Pakistan’s insurance sector has experienced
accelerated growth and robust profitability,
augmenting its overall risk absorption capacity
in recent years.
• Now faces major challenges arising from various
broad socio-economic risks, including ongoing
stock market turbulence, rising trend in the
interest rates, widening fiscal and trade
imbalances and worsening security conditions.
• The rising interest rate scenario has already
dampened auto financing, besides impairing
business initiatives hitherto demonstrated by
large-scale manufacturing and SMEs.
• PACRA, therefore, sees pressure mounting on
the insurance sector, which may impact its
growth prospects, profitability and liquidity,
undermining its overall financial strength.
BANKING SECTOR
• Most of the commercial banks have announced
their full year financial results for the period
ended Dec 31st 2009. Two main observations
deserve a specific mention:
▫ Investment in government securities: In a
high interest rate environment, the banks
normally prefer to invest in the safer government
securities and papers like treasury bills even if
they fetch lower interest earnings
▫ The “crowding out” of the private sector means
that the economic growth will suffer, resulting in
industrial closures, bank defaults and massive job
losses.
▫ Rise in Non performing loans.
• The banking spread, difference between lending and
deposit rates, reached a record level of 7.78 per cent
in January. It is considered to be negative for
depositors.
• In times of such high inflation it is difficult to say
that depositors will get real positive return.
• Banks are lending in the range of 18 to 27 per
cent. The highest cost is paid by small borrowers
as consumer loans are charged with highest
interest rates.
AUTO FINANCING
• Use of high interest rates as a tool to curb
inflation is drying up private sector credit
demand; this is a worrisome situation for many
banks, as at the moment our economy needs a
boost through credit demand which can trigger
GDP.
▫ First & most important reason is hike in interest
rates.
STOCK MARKET
• The escalated interest rates had increased
borrowing costs and severely dented growth in
the economy.
• Major industries like manufacturing and
services sectors were highly leveraged and this
higher interest rate scenario had blanked their
expected future growth.
• The financial performance of all the companies
and sectors deteriorated and hence the
investment markets, especially the stock market,
dived down to their lowest.
• Due to manufacturing and service sector decline,
the foreign direct investment FDI in Pakistan,
which was growing at a robust 5 year cumulative
aggregate growth rate (CAGR) of 52.65% and the
total foreign investments at 42.46% have dived
to their lowest.
• Portfolio investment in stocks have been most
volatile, which stood at US $ 311 million during
FY-04, marked high of US $ 3,288.30 million
during FY-07, but declined to US $ 40.16 million
for the FY-08.
• In short, the stock market has been hit three
folds due to increasing interest rates:
▫ One is CFS financing, which was the main elevator
of stocks.
▫ Secondly, industrial decline resulted in lower
forecasting of future stock prices.
▫ Declining index, people started saving and
investing in commodities which created a liquidity
crunch in the financial market
• The escalated interest rates finally made the
stock market to discount its values by more than
50% and touched 4000 points from above 15600
level’s peak.
RECOMMENDATIONS
• After months of tight monetary policy now there
is a cut in discount rates to 12.5% but it should
further brought down.
• If a high discount rate has resulted in lower
growth and prolonged high inflation then a cut
in discount rate could mean higher growth and
lower inflation.
• Following is our analysis of what the possible
effects of a sharp cut in discount rate could be:
▫ Potential Consequences
 Many analysts warn that a sharp cut in discount rate
could put pressure on the exchange rate, lead to
currency depreciation and foreign exchange drain,
wiping out all the macroeconomic gains made so far
to stabilize the economy in the recent months.
▫ Potential benefits
 For an emerging economy like ours, nothing is more
important than growth. And, a cut in discount rate
may well achieve that due to the simple reason that
growth and discount rate are two negatively
correlated terms, at least as far as our economy is
concerned.
 As growth bounces back and businesses become
more profitable, foreign investors would once again
bring their money here resulting in foreign exchange
inflow and stronger rupee which in turn will result in
lower imported inflation
 The stock market will revive, creating greater
availability of capital and an option for businesses to
substitute debt for equity. This would result in
greater profitability and make the stock market even
more attractive to the investor. The end result would
be a vibrant economy, stronger rupee and thus a
lower and economically viable inflation rate.
CONCLUSION
• The above comparison shows that the case for
cutting discount rate is certainly very strong.
▫ The central bank should reduce its discount rate
gradually to ensure exchange rate stability.
▫ Inflation in our country remains sticky not
because of aggregate demand pressures but due to
lack of administrative control over the prices of
commodities, therefore the government must
monitor prices in the market to control inflation
▫ In economic crises the staggering amounts of
nonperforming loans the commercial banks are
charging very high interests, therefore even after
the cut in discount rate the central bank should
ensure that the commercial banks are advancing
loans to foster economic growth.
▫ The SBP must monitor closely the lending
practices of the commercial banks.
▫ The SBP must force the commercial banks to
reduce their banking spread so that the benefit of
lowering discount rate also reaches the general
public