The State Bank of Pakistan (SBP) announced a 150 basis point (1.5 percent) reduction in the discount rate on October 8, 2011. This decision was received with a mix bag of feelings. The move was welcomed by the private sector yet the economist speculated at its efficiency in achieving the desired effect. The banks however are scrambling their forecasts for the next year as the booming profits made on the wave of existing spreads may now be squeezed.
The Private Sector:
The downward revision of the discount rate indicates the SBP’s vision to provide a kick-start to Medium and Large-scale businesses. Since the discount rate is directly linked to the lending rates of banks, cost of credit will significantly reduce. Low lending rates will encourage businessmen to increase their activities and utilize running finance facilities and loans. Increased business activity will stir up the industrial sector. Lower interest rates will positively influence the textile, cement, fertilizer and manufacturing sector as cost of business will come down. Highly leveraged companies can also breathe a sigh of relief, as financing costs will be reduced.
The Banking Sector:
Although the reduction in the discount rate was not a surprise to bankers, the quantum (150 basis points) was unexpected. In the face of such a big slash (the last such big slash was in 2009 when the SBP reduced the discount rate by nearly 200 basis points as shown in the chart below) banks are facing the challenge to match the profits that they posted last year.
For banks, a discount rate cut means that the spreads on deposits will shrink. Banks keep deposits of customers and give them a certain rate on their deposit savings. Once the bank has these funds, they either lend them out (to businesses, individuals) or make investments in T-Bills, Government securities etc. The bank then earns on these investments or receives interest from the borrowers on loans. When interest rates are high, banks give a higher return to their deposit customers and more individuals are willing to keep their money in bank accounts. Banks then have more money lent out or invested at higher rates. The difference between the deposit rate and the lending rate is the spread, which the bank earns.
In individual capacity, a person is either a saver or a borrower. A saver or more accurately a depositor is any person holding a savings account earning interest on the money placed in the bank. A change in the discount rate directly impacts this interest earning of savings accounts. When the interest is high, people prefer to place their money in their savings accounts and even book longer tenured term deposits with higher rates of returns. However, when interest rates drop, it becomes less profitable to keep money in bank savings accounts. A lower discount rate therefore, encourages people to either spend more or look for other avenues for savings/investments. This then leads to fuelling of markets such as shares and stocks, mutual funds, savings certificates, TFC’s etc.
On the borrowing side however, the discount rate cut would mean lower interest on loans. Installments of personal loans, auto loans, mortgage loans and any other type of financing facilities, which an individual may wish to take, would be more affordable. A key factor associated with lowering of interest rates is to increase the buying power of the individuals, which would then lead to increased economic activity based on the demand and supply methodology. Since a higher demand would induce a spur in production related activities, it should in an ideal situation create more jobs in the market.
Although on first analysis it may seem that decreasing the discount rate will be a boon to our stagnant economy, it is very important to be mindful of two particular aspects of this move. One, no matter what policy decision is taken and implemented by the SBP, its effects will not be over night. Before jumping to any conclusions it is important to let this step (of discount rate reduction) go under its gestation period. The real and practical effects of it will only be visible minimally by the first quarter end of the next year. Making credit easy for the consumers will definitely trigger a chain of events but how those chain of events make the domino effect is a not a short sighted goal. Credit boom leading to industrial growth will be a slow process. The banks will again be faced with the mammoth task of ensuring that readily available credit is effectively injected into the economic bloodstream and not converted into a burgeoning book of non-performing loans.
The second most important factor may entail further inflation. As the economy heats up, it is bound to increase inflation. Again, the simple law of supply and demand will come into play. Once the positive impact of increased production reaches the maximum capacity then the push will be on the price. A simple example will illustrate this phenomenon. As demand (fueled by increased purchasing power of individuals) goes up, manufacturers will increase supply to meet that demand. Factories that were using less than 100% of their capacity will optimize their capacity and meet the rising demand. Once they maximize their output potential and the demand continues to grow, it will surpass supply and cause the prices to go up causing inflation.
Therefore, it is important to understand the entire picture rather than uttering blatant statements. Yes, under the current circumstances, lowering the discount rate may provide a kick but how effective and long lasting the kick is remains to be seen and that is what actually matters. Sustainability of any decision is probably its biggest strength.
Currently, a number of large companies in the FMCG (fast moving consumer goods) and fertilizer sector have breathed a sigh of relief. These companies being highly leveraged will see a positive impact in their balance sheets as the cost of KIBOR linked financing will go down. However, as discussed in depth above banks are in a tight spot to manage their liquidity. Therefore, a stimulus has been injected into the economy and further policy changes may ensue both on the monetary and fiscal side as and when required to steer the economy on a positive path.