Just like the rules of war and laws of nature, economic principles have a way of punishing with vengeance those who defy them. Over the last couple of months, a troublingly ill-informed narrative was built around the interest rate regime in Pakistan. Firstly, the entire debate was a victim of the media’s sciolism and devoid of any mention of the real interest rate. Second, a strawman argument was built around how the increase in interest rate will do little to curb inflation caused by supply-side policies. Third, the link between the interest rate and the government’s deficit financing was totally ignored. And lastly, the consequences of lowering interest rates for exchange rate stability were never brought into question.
Real interest rate is what investors actually earn in real terms. It takes out the effect of inflation from the nominal interest rate. The policy rate set by the State Bank is a nominal interest rate. Suppose that the policy rate is 12 percent while inflation is 9 percent, then the real rate that investors earn is only 3 percent. Economic decision making is always based on real – not nominal – interest rate.
Consequently, all household and business decision making including consumption, saving and investment responds to the real interest rate. When Central Banks lower interest rates they are making it cheaper to borrow and essentially pushing the economy to take risk, with the hope of more investment leading to higher economic growth. Though most of the time, fluctuations in nominal interest rates reflect changes in inflation more than changes in real interest rate.
It is true that high real interest rates stifle investment, make it harder for businesses to expand and ultimately hurt economic growth. The question is if we actually had a high real interest rate? For the record, if it has any weight, the real interest rate in Pakistan has actually been lower than in the past few years. According to IMF data, Pakistan had a real interest rate of 7.12 percent in 2012, 8.32 in 2016 and 5.91 in 2018 while according to unofficial estimates it was 5.30 in 2019. The average real interest rate from 2012 to 2018 was 5.70.
Why do we then have a narrative built around prohibitively high interest rates in 2019 but not in 2015-2016? The answer is that our media pundits are looking at nominal interest rates which have indeed been the highest in a decade. To be fair, some businesses bear a disproportionate cost of higher nominal rates. One may question that if real interest rates are unchanged then why do some businesses find it relatively expensive to borrow? Suppose that the State Bank raises nominal rates in line with inflation to keep the real interest rate unchanged. An average business should be able to raise prices in line with inflation and be able to pay a higher nominal – yet unchanged real – interest rate. Some businesses, however, are unable to pass on higher prices to consumers but end up having to pay a higher nominal rate and consequently a higher real interest rate. Macroeconomic policy, of course, is never built to cater to a few businesses or a specific industry.
For the sake of an informed debate, the raison d’etre of raising the interest rate in the first place must be studied with a fuller and impartial perspective. If the government borrows money to finance a payback of a loan or to finance its spending, it will borrow from the existing pool of limited national savings. A higher interest rate increases the pool of savings and makes it easier to borrow. As the Advisor on Finance pointed out, the government has to repay Rs5000 billion in two years. A high interest rate incentivises lending to the government. If the government fails to raise these funds, it will have to ask the State Bank to accommodate its deficit by printing money – which will be inflationary. So far, the economy has experienced double-digit supply-side inflation but if a massive loan payback is financed by monetary accommodation it will unleash an even bigger wave of demand-side inflation. Choosing between price stability and economic growth, most Central Banks sacrifice growth to maintain price stability as is their primary mandate.
Contrary to what some media pundits have alleged, a high interest rate is not a pursuit for hot money. No Central Bank deliberately seeks short-term investment that can evaporate in days. In absence of long-term foreign investment, any short-term investment is still welcome to bridge a funding gap which would otherwise have to be bridged with a Eurobond auction. Hot money inflow is better than no money inflow, and a prospective first step towards medium term investment, granted macro stability.
During global slow down, investors rush to safe havens such as USD denominated assets. At a time when the US nominal rate is at zero percent and the real interest rate is in negative territory, investors are still rushing to buy US assets. In the last month, the US dollar saw a non-trivial appreciation against a basket of currencies. For reference, the US dollar rose 12 percent against the British Pound and 28 percent against the Mexican Peso. In the last sixty days investors have pulled out $83bn from emerging markets. Economic slowdowns increase the risk premium for emerging markets, which might seem unfair, but investor preferences are not driven by the principle of fairness. Lowering interest rates at this time could lead to capital flight and pressure on the exchange rate which can be a crisis in its own right.
It is not to say that any fiscal stimulus or monetary easing is a bad idea, but that its consequences must be fully understood. Reducing the debate to simplistic ideas as discussed on talk shows is dangerous, to put it politely.
