Poke the Bubble – Journal

IT is well known that monetary tightening causes hardship for borrowers as interest rates rise, making loans expensive. Excessive emphasis on cost may be part of human nature. Observe any child who is about to be pricked with an injection needle; he struggles to avoid the shot. Fortunately, his elders are wise and hold him tight to get him through the process. The cost to bear is short-term pain, while the health benefits are long-term.

Monetary tightening is no different and involves pricking the economic bubble. Short- and medium-term pain is endured to achieve long-term economic health benefits. Unfortunately, the elders of our economy generally behave like little children and try to avoid the blow until economic disease leads to the depletion of fluid reserves and the loss of growth electrolytes. And it is rarely our own hand that provides firm support. Many politicians, media pundits and economic pundits then resort to the familiar narrative of lost sovereignty, unbearable debt burden and interest charges, indirectly implying that the child was right and the vaccine should not have been. be administered. This seems to be, unfortunately, the collective mindset that still constrains us, as evidenced by the fact that we still remain underdeveloped in the 75th year of our independence and that we are still trying to eradicate poliomyelitis.

Short- and medium-term pain must be endured to achieve long-term economic benefits.

The real benefit of appropriate tightening is in reducing inflation and tempering the overheated economy, preserving precious reserves from depletion, and putting the economy on a growth path. sustainable. The path to lower inflation has costs for borrowers and benefits for depositors. There were about 62.9 million deposit accounts and 3.9 million loan accounts in our commercial banks at the end of June 2021, according to the State Bank Statistical Bulletin March 2022. Although the actual number of borrowers and depositors is not available, what matters for our analysis is the number and size of these accounts. Deposits were around 19.1 trillion rupees and total loan amount was 8.7 tr. These include loans to public sector enterprises (PSE), but exclude credit granted by commercial banks through their investments in government securities (T-bills and GDP). Government borrowing through national savings schemes is excluded. Government borrowing from the State Bank is also not included in this data.

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Meanwhile, government borrowing from commercial banks through treasury bills was Rs6.2tr and GDP was Rs6tr. Government borrowing from the State Bank was also Rs6tr. Borrowing through national savings schemes and price bonds was Rs3.9tr. We can safely exclude borrowing from the State Bank in this benefit-cost analysis because any additional interest paid to the government accrues to it through the transfer of profits from the State Bank. Remember that the NSS rates are not linked to the State Bank’s policy rate and this borrowing could also be excluded from this exercise, as government interest charges directly benefit individual savers in these schemes. Nevertheless, we also account for this cost.

From June 2021 to January 2022, the State Bank’s key rate increased by 2.75 percentage points (from 7.0% to 9.75%). Six-month Treasury bill rates increased by 3.07 percentage points (from 7.56% to 10.63%); The 10-year GDP rates by 2.06 percentage points (from 8.87% to 10.93%) and the rates for special savings certificates by 2% (from 8 to 10). in the previous paragraph) of Rs190 billion + 124 billion + 78 billion, i.e. Rs 392 billion in FY22. Let us now capture the interest cost of other borrowers, including the private sector and PSEs. Weighted average lending rates on outstanding loans increased by 1.34 percentage points (eight to 9.34), imposing an additional interest cost of Rs 117 billion (1.34% of 8.7 tr) . The total interest cost to borrowers is therefore Rs 509 billion.

While almost everyone knows that our government is the biggest borrower, few know that it is also the biggest depositor (along with ESPs) in commercial banks. Of the total deposits, about Rs4.1tr belonged to the government and PES! The weighted average return on deposits increased by 1.56 percentage points (3.56 to 5.12). This means that all depositors are expected to earn 298 billion rupees on deposits of 19.1 billion rupees in circulation by the end of June 2021. Therefore, the interest cost of monetary tightening is 209 billion rupees. It is the cost over one year that will benefit from monetary tightening.

A 100 basis point increase in the discount rate leads to a reduction in inflation of nearly 200 basis points in three years, or 66 basis points in one year according to Bank of India Working Paper No. 80. ‘State. inflation increased by 275 basis points from July to December 2021, inflation should be reduced by 550 basis points in three years, or 183 basis points per year on average. The pecuniary benefit of this reduction in inflation is simply 1.83% of the real value of the GDP of the financial year 21 (Rs36.5tr), or approximately Rs668 billion.

Again, a crucial assumption in this analysis is that economic growth exceeded (or approached) its potential before tightening. Another important assumption is that the exchange rate is fully aligned with our economic fundamentals, i.e. central bank foreign exchange reserves are rising (at best) or not falling (at worst). Any drop in reserves will quickly erode the benefits of the tightening.

At the current exchange rate of about 183 rupees to the dollar, a decline of $1 billion will erode 183 billion rupees of the net benefits estimated above. It can be noted that the State Bank’s foreign exchange reserves decreased from a high of $20.1 billion on August 27, 2021 to around $15 billion on March 18, 2022. This is a decline approximately $5 billion. It appears that the monetary benefits of a year of rising interest rates have been wiped out by the depletion of reserves. Our economy is once again fast approaching a balance of payments crisis as our wise politicians on all sides engage fiercely in a game of thrones.

The author is a former Deputy Governor of the State Bank of Pakistan.

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Posted in Dawn, March 31, 2022

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