Analysts perplexed by SBP’s sudden increase in policy rate

KARACHI: The State Bank of Pakistan unexpectedly raised its benchmark rate to a record high of 22 percent in an emergency meeting on Monday, which analysts criticised saying the move was more to appease the International Monetary Fund than curb cost-push inflation.

The SBP Monetary Policy Committee (MPC) hiked the policy rate by one percentage point to 22 percent in a meeting held just after two weeks of a regular meeting. On June 12, the SBP had left the rate steady considering weak domestic demand and expectations for a decline in inflation after June.

“I am surprised to see SBP's justification for raising rates today,” CEO of Alpha Beta Core, Khurram Schehzad, stated on his official Twitter account.

The SBP cited tax increases in the budget to be one of the key reasons for raising rates. Taxes are administered through price changes. So interest rates cannot control taxes, especially when taxes are imposed on incomes instead of consumption, according to Schehzad.

Two noteworthy events that have had a negative influence on the inflation forecast and may put additional strain on the already strained external account have been recognised by the MPC. First, the National Assembly's recent approval of the FY24 budget has resulted in increases in taxes, tariffs, and the petroleum development levy rate, prompting questions about how these would affect the outlook for inflation as a whole. Second, a key development is the SBP's recent decision to withdraw its general guidance to commercial banks on import prioritisation.

The goal of meeting the requirements of the ongoing IMF programme has driven the decision. The MPC accepts the need for the actions but also that they have increased the upside risks to inflation and the exchange rate.

“How can tax increases cause inflation when the tax itself is having an impact on disposable incomes, reducing aggregate demand, and causing expected drops in prices? Since these taxes have been placed primarily on income, they will only reduce the economy's already low disposable incomes in a recessionary scenario,” Schehzad explained.

Analysts say the SBP's decision to raise interest rates as a last-ditch effort to clinch a crucial IMF programme that is due to expire on June 30. The government's revised 2023–2024 budget, which complies with the IMF requirement, was approved by the parliament on Sunday. The SBP lifted all import restrictions over the weekend. These events suggest that the nation is nearly through with the IMF's ninth review.

The main cause of overall inflation is food inflation, which is mostly brought on by supply shocks.

With imports reduced and a parallel smuggled economy growing, how could an increase in rates stop the informal economy (smuggling) rather than just putting further pressure on the official sectors? Other than the IMF, what else served as justification for rate changes, Schehzad questioned.

Ehsan Malik, CEO of Pakistan Business Council, said the 100bps point increase like previous ones would not stem cost-push inflation and was clearly aimed at pleasing the IMF. Amongst the reasons given for the increase is the relaxation of imports.

“One wonders how with the current precarious level of forex reserves, the MPC could possibly believe that imports can be relaxed. Secondly, higher taxation will reduce disposable income, hence demand, so that cannot be a reason to increase the policy rate either,” Malik said.

A 30 percent increase in government salaries and revision in pensions could and the government should have factored in the inflation risk when proposing the level of increase in the budget. “It will now be burdened with even higher debt servicing cost,” Malik added.

“Every which way you look; the formal private sector and those who work for it are losers. Higher taxes, now the even higher cost of borrowing, in an illusion of import relaxation - they must think the private sector has unlimited capacity to absorb these shocks. It doesn’t and the consequences of these shocks will need to be addressed by the next government according to Malik.

Some analysts were of the view that Pakistan will unlock inflows from friendly countries as a result of the resumption of the IMF programme.

“This sudden development confirms that discussions with IMF are happening at a frenzied pace. An IMF deal at this time will be a huge confidence booster for Pakistan, as it will catalyse other inflows from multilateral sources including World Bank and IDB," said Komal Mansoor, head of research at Tresmark. After repaying some external debt in FY2023, which affected the foreign exchange reserves, Pakistan's debt repayment for the next 12 months (June 2023 to May 2024) is $20.7 billion, according to Topline Securities. In 11 months of FY2024 Pakistan has to pay $17.6 billion while a few days back SBP governor estimated full-year FY2024 debt repayment of $23 billion.

“Though debt repayment is coming down, without IMF or/and support from friendly countries it will be difficult to manage considering current net liquid FX reserves of $3.5 billion (excluding public $ deposit of $5.3 billion and gold reserves estimated at $4 billion),” the brokerage said.