The decision of the State Bank of Pakistan to hike its policy rate by 50 basis points to 12pc is quite expected considering the increasing dangers to the stability of prices and uncertainty regarding the global economic outlook.
The decision may not please the business community as a result of increased interest rates, but the central bank has no choice because of the need to maintain the results of the stabilization efforts. Against the background of persisting international inflation, high interest rates and vulnerability of energy prices to political factors, the rise in inflationary pressure may be harmful for the country.
Pakistan has achieved some success in improving its external situation. Stable currency exchange rates, the growth in the amount of foreign exchange reserves and remittances have positively affected the balance of payments of the country. Nevertheless, it would be inappropriate to consider all these positive trends as the solution of the problems associated with external vulnerabilities of Pakistan. There are still a number of threats from the international environment.
The international economic environment has been growing more difficult. Major central banks are finding it hard to control inflation and manage the delicate balance of maintaining growth. According to the IMF projections, high prices continue to be an issue in most countries. Higher interest rates in international markets are also creating competition for resources, which means it will become harder for developing countries like Pakistan to find investments at reasonable costs.
In this situation, the SBP should be prepared for the scenario in which inflationary expectations may become a reality. Any pressure on the value of the national currency will raise the prices of imports like fuel, machinery and other materials. Exchange rate stability due to low demand for imports does not mean that the problems in the external sector have been resolved. If imports suddenly spike, oil becomes expensive internationally, or international monetary policy tightens, these issues can be exposed easily.
This recent rate increase is therefore a precautionary step towards maintaining macroeconomic stability and not a measure taken to stop economic activity forever. If the inflation rate is allowed to increase further, then more tightening of monetary policies will be needed, which would cost more for business and people alike. By taking steps before inflation becomes too much of a problem, the government intends to ensure that it does not undo its earlier efforts of controlling the rate of inflation and keeping the currency stable.
While the policy decision has been welcomed by many, some parts of the economy have been against it. Foreign investors in particular have welcomed this move since they believe it is needed to control inflation and stabilize the currency. Higher interest rates may lead to better financial products in the domestic market and hence attract foreign investors. This is particularly helpful at a time when international conditions are uncertain.
Moreover, according to industrial associations, expensive credits will negatively influence manufacturers’ plans to enlarge their capacities, modernize equipment and initiate new investment projects. Small and medium-sized companies are especially exposed to such risks since they usually have limited opportunities for acquiring alternative financial resources. If the cost of borrowing increases, companies will be compelled to refrain from expansion, decrease working capital and limit production.
These issues need to be taken seriously into consideration. The industrial sector of Pakistan has still not fully recovered, and the continuous high interest rates can prove to be detrimental to the formation of a stronger productive base because businesses need inexpensive credit so that they can adopt modern technology and compete in the international market. Should the cost of credit remain too expensive for a considerable time span, domestic manufacturers would become uncompetitive compared to the manufacturers in countries where credit and energy are relatively cheap.
Still, the monetary policy cannot be determined only through the needs of businesses in relation to credit facilities. The central bank has to think about the consequences of the inflation, currency instability and changed global financial situation. The problem with high inflation is that it erodes the purchasing power of the people and discourages investment due to uncertainty of prices.
However, it would not be realistic to assume that monetary tightening will be able to solve the problem of inflation in Pakistan on its own. Interest rates can control excessive spending and borrowing and have an impact on inflation expectations and exchange rate stability. But they cannot affect the ability of producing more electricity, reducing fuel imports, increasing productivity of agriculture, or eliminating inefficiencies in supply chain management. In the case when inflation is caused by high production costs, monetary tightening is clearly ineffective.
And this is where the role of the government becomes extremely crucial. Sustainable recovery for the industry cannot be achieved without reforming the cost of doing business, and not just by resorting to monetary tightening. There should be a fundamental transformation of the energy sector, which will make sure that industries receive stable electricity and gas supply at low prices.
Tax reform is just as crucial. With a small tax base and successive increase in the tax burden of existing taxpayers, the investment process suffers and the incentive for businesses to operate outside the taxation system is increased. The inclusion of undertaxed areas within the tax system along with simplified processes and stable taxation system would certainly help businesses in creating a level playing field. Reforms in the regulatory framework are also essential in order to remove any excess administration and policy uncertainty for the investors.
In this case, both the government and the central bank need to pursue complementary policies. As far as the SBP is concerned with the task of maintaining low levels of inflation and external stability, the government should work on supply-side constraints and public spending management reforms. This would eventually help in creating some room for a lower interest rate policy.
In light of all the factors, Pakistan cannot afford another situation wherein there is an improvement in the inflation rate and reserve levels temporarily only to have the country slide into yet another economic crisis. The reality of the situation is that the recent increase in the policy rate might be necessary because of the risks to the economy, but it must not act as an excuse for postponing crucial changes. Monetary tightening can help create a shield for the economy temporarily in order to prevent inflationary threats, but ultimately any help for the economy will come from reduced energy prices, wider tax base and increased productivity and consistency of policies.