It’s time to cut the discount rate

A cut in the discount rate should be seriously considered by the SBP in its upcoming monetary policy committee meeting. Some basic facts to consider are; a less than 9% average CPI for FY14 (far lower than SBP initial estimate of 11-12%), a reasonable forex parity in real terms (especially after the 5% depreciation in the previous weeks), rising forex reserves which are near a record high and a considerable spread between government paper and inflation, all which justify a rate cut.

Following sturdy inflation in the previous months, prices of key essential items have started to ease off as evident from data released by the Pakistan Bureau of Statistics (PBS). Incorporating the price trend highlighted in recent SPI readings, the Consumer Price Index (CPI) for Aug’14 clocked in at 6.9%YoY, almost 100bps lower than 7.9%YoY registered in Jul’14 and almost 200bps lower than 8.6%YoY registered in Aug’13. Average inflation of 7.45% for 2MFY15 translates into a positive real interest rate of 255bps when compared with current DR of 10%. At the beginning of the year SBP was of the view that CPI for FY14 will range in 11-12% and accordingly SBP increased interest rates by 100bps during 1HFY14, however, inflation eased sharply in FY14. As for FY15 CPI is estimated to range between 8-9%. Real interest rates are at a record high with a spread of 450bps between inflation and actively traded 2-year government paper. Therefore, this is the time for SBP to realign its monetary policy to the changed inflation outlook.

Supporting my push for an interest rate cut are the recent signs of an economic recovery. After a long gap, Pakistan economy has shown clear signs of improvement. This is evident by private sector credit and LSM growth, booming property and stock market, etc. With lower inflationary risk, a cut in the discount rate will provide the necessary push to the already improving business environment and GDP growth. We believe that SBP should place higher weight on falling inflation and better external position so that economy could reap the benefits of positive sentiments. After a gap of 6 years, advances of Pakistan scheduled banks grew by 10.8% in FY14 to reach Rs 4.3tn compared to 3.4% in FY13. The advances growth is highest since the 2008 economic crisis and is broad-based in the sense that it financed external trade activities, working capital, fixed investment and consumer financing. On the other side, private sector credit showed a healthy growth of 11.3% also after a gap of 6 years. In 1H2014, advances grew 5.3% compared to a growth of 0.3% in 1H2013. During FY09-13, advances grew at CAGR of 5.6% despite a 13.8% deposit growth as banks refrained from lending due to risk aversion and unattractive business outlook. Consequently, Advances to Deposits Ratio (ADR) declined from 77% in FY09 to 53% in 2013, while credit penetration (advances as a percent of GDP) dropped to multi-year low of 19%; lowest among regional and comparable economies. The same ratio in India is 54%, Bangladesh 48%, Sri Lanka 42%, Nigeria 29% and Vietnam 105%. However, reduction in government borrowing, better country outlook after new government took charge and rising industry credit appetite shifted banks’ focus towards private lending in FY14 and resulted in a stable ADR of 53%.

Broad money growth, during July 2013 to June 27, 2014, remained at 12.2% vs. 15.9% in FY13. A slower monetary expansion is mainly linked to limits on SBP’s NDA (Net Domestic Assets) and limits on Government. borrowing from SBP. Within M2, strong foreign inflows improved NFA (Net Foreign Assets) by Rs 327bn in FY14 to total Rs 596bn by June 27, 2014 compared to a contraction of 263bn in FY13; this figure had dipped to Rs 5bn on December 6, 2013. However, this expansionary impact was offset by a slow NDA expansion by Rs 753bn vs. Rs 1.5tn in FY13. In line with M2, deposits of Pakistan schedule banks grew at 10.5% in FY14 vs. 14.3% in FY13. This growth rate is the lowest in last 5 years. Pakistan scheduled banks Investments growth also remained low in FY14 as overall growth remained at meager 5.6% versus 30.2% in FY13. Both the lower fiscal deficit and availability of non-bank funding helped reduce government reliance on the banking system. As a result, scheduled banks Investments to Deposits Ratio (IDR) reduced to 53% from 56% in FY13.

According to the latest data released by SBP, the government’s short-term domestic debt obligations, with a maturity period of less than a year, have also significantly come down to PkR4.6tn or 42% of the total debt burden by the end of June, reducing rollover and re-financing risks. There was also 11.5% or PkR596bn reduction in the short-term domestic debt stock. However, this has come at a price, as the long-term debt was primarily raised by issuing Pakistan Investment Bonds (PIBs), which is an expensive source of borrowing. The cost of short-term debt was around 9.5% to 10% while the average cost of PIBs is in the range of 12.5% to 12.8%, increasing the country’s debt servicing cost by approximately 3%. Keeping the governments disciplined borrowing, subsiding inflation pressures, banking sector ADR ratios, credit penetration, changing debt profile and the billions of rupees that will be saved in debt servicing, a discount rate cut should be seriously considered.

Due to IMF’s previous loan repayments and low foreign inflows, the country’s forex reserves dipped to US $7.6bn on February 6, 2014 (SBP reserves US $2.8 billion, below 1-month import cover). However, disbursements from the IMF, issuance of US $2 billion Eurobonds and inflows from friendly countries have resulted in improved forex reserves of US $12.9 billion. Improving FX reserves have also resulted in an excellent cushion for the local currency (bar political upheavals), thus supporting my stance.

Those, who believe that rates will not decline in upcoming MPS base their argument on, firstly, upcoming expectations of electricity and fuel inflation as government plans to further reduce subsidies especially on energy prices and, secondly, the IMF pressure. Regardless of increase in power rates, I believe average inflation in FY15 may range between 8-9% supported by a stable PKR above the 100 level. The IMF instructions, frequently quoted, are also misunderstood as it has been insisting on the independence of central bank. Thus an independent person sitting on the SBP board would use his own wisdom rather than just reading the IMF notes.

Keeping all the above in mind I believe the policy rate in Pakistan should go down by an aggressive 100bps to stimulate growth (incidentally also part of the SBP mandate) in its next meeting.