SBP's increase in policy rate dismays policy makers, practitioners

Usual coterie believes price inflation to be mostly issue emanating from cost-push factors, rather than increasing demand

Ammar Habib Khan
The State Bank of Pakistan (SBP) building. — AFP/File
The State Bank of Pakistan (SBP) building. — AFP/File

The State Bank of Pakistan recently increased its policy rate by 1% to 16%, much to the dismay of many active, passive, and armchair policymakers, and practitioners. 

As price inflation continues to clock at a level greater than 25%, the usual coterie continues to believe that price inflation is mostly an issue emanating from cost-push factors, rather than increasing demand driven by an increase in money supply.

As the commodity super cycle gained traction earlier in the year, its effects were felt by commodity importers across the globe, more so by economies that had relatively high money supply. Excess money supply effectively compounds any effect of commodity cost-push, as that adversely affects the exchange rate resulting in a double whammy.

Let’s understand at a very elemental level how interest rates actually work. On a fundamental level, interest rate is essentially the "price of money". The price of any commodity or service is essentially a function of its demand and supply. Where both demand and supply meet, that is the market clearing price.

In the case of "money", there is demand, and there is supply. The largest borrower in the country is the government itself, which makes up almost 70% of all borrowing from the formal loanable funds available in the country. As the demand of funds continues to increase, so does the potential interest rate, as demand outstrips supply.

The demand of the government is largely driven by its inability to increase tax revenues or control expenditures. A habit of running recurring and persistent deficits has resulted in a scenario where the government continues to borrow heavily to balance its books. 

As it keeps borrowing more, the demand continues to increase and so does a market clearing interest rate. This also leads to a crowding-out effect, wherein government borrowing crowds out private-sector borrowers, making it increasingly difficult for private borrowers to access capital thereby hurting investments.

But what about the supply? The supply for money is actually increasing in terms of currency in circulation, which exists outside the system. The currency exists, but in the form of cash, we exist outside the formal financial system, and hence cannot be used as formal supply to meet increased demand of the government.

Effectively, what is happening is that supply of money in the formal financial sector remains constrained, while it continues to increase in the informal market. It is estimated that currency in circulation as a percentage of GDP increased from roughly 8% in 2012 to almost 20% in 2022. 

Currency in circulation in the economy has more than quadrupled during the same period. So, instead of being in the system and enabling redeployment of the same to more productive activities, it remains outside the system, pumping up the informal economy.

Government policies over the years have encouraged the accumulation of capital outside the formal economy through a mix of anti-industrialization taxation policies, and an ever-accommodating stance towards real-estate investment. It makes more economic sense for anyone with cash to deploy the same in synthetic real estate exposure through ‘files’, rather than deploying the capital towards areas that can create additional jobs, and exports. 

Concessionary loans air-dropped as a knee-jerk reaction to the pandemic created a massive monetary stimulus, which further increased the prevalence of cash in the economy.

As funds remain out of the system, and as the same continues to flow out of the formal system, it gets increasingly more expensive for government and other private sector entities to borrow since the demand for funds continues to increase, but supply in the formal segment remains constrained. A natural consequence of all this is a higher equilibrium interest rate.

As the quantity of cash in the economy explodes, it starts seeking goods or services to buy. But to produce goods and services we need to invest in either manufacturing, or services capacity — effectively restricting aggregate supply in an economy. But since we kept capital out of the formal economy, such capacity could never develop.

Hence there is a lot of cash chasing too few goods and services. As demand increases in an environment of restricted supply, price levels increase, resulting in inflation across the board. 

This also has an adverse impact on the exchange rate, because the cash-seeking local goods and services is also seeking goods and services produced outside of the country, resulting in an increase in imports, and a pressure on the local currency resulting in the depreciation of the Pak rupee.

In such a scenario, the opinion of men (almost always men) that high-interest rates are detrimental to an economy is flawed, as high-interest rates are a symptom of a much bigger structural problem. If we want lower equilibrium rates, it requires structural reforms that reduce the incidence of cash in the economy and forces a government to balance its budgets and reduce its reliance on debt to bridge its deficits.

We cannot throw money at the problem in perpetuity, and expect inflation to remain mute. Inflation is a tax on the citizens of a country perpetuated by the wisdom of the same men who like to throw money at the problem rather than fixing structural problems.

The writer is an independent macroeconomist.

Originally published in The News