Karachi, May 10, 2023 (PPI-OT): IMF: Stepping out of the realm of logic
The IMF’s latest demand is for further interest rate hikes in the country, with some media sources reporting an increase to as much as 25%. The SBP stated that real interest rates, based on FY24 inflation, were finally in the positive region, indicating FY24 avg. CPI inflation of less than ~21%.
High base established in inflation readings this year sets the stage for inflation tapering off in the latter half of FY24. Consequently, we see inflation next fiscal year to average 20.8%YoY.
Keeping in mind AKD’s estimates and those referred to by the SBP, raising interest rates to levels that reflect 4-5% spread on inflation, with ongoing economic challenges in the backdrop, would be detrimental to Pakistan’s economy and bring activity in the country to dangerously low levels.
With cost of borrowing already north of 1/5th of principal amount, servicing debt or taking on new debt for corporations and individuals has become an uphill battle—no longer making fiscal sense. This is also being reflected in the Advances portfolio of leading banks, wherein terminations have been rampant and attracting demand for loans has been a challenge.
As has been apparent from inflation readings thus far in FY23, heightened interest rates have been unable to transpire the intended effect on inflationary trends. Core inflation has continued to follow an upward trajectory despite cumulative rate hikes of 1,400bps since Sep’21. Hence, it is evident that the cost of heightened interest rates outweigh its benefits.
On a broader level, heightened interest rates would also be detrimental to fiscal operations of the country, as it increases the cost for the GOP to service sovereign debt.
Has the IMF lost the plot?: According to remorse in the market, the IMF’s latest demand is for further interest rate hikes in the country, with some media sources reporting an increase to as much as 25%. To recall, the SBP raised the policy rate in the country by 100bps to 21% in Apr’23, with a cumulative increase of 1,400bps since Sep’21. In its last post-MPC briefing, the SBP indicated that real interest rates had finally come back into the positive territory with policy rates at
21%—based on inflation readings for FY24. Interest rate hikes are intended to curb consumption in the economy. However, despite the recent interest rate hikes, inflationary pressures have persisted. Core inflation, i.e. Non-Food Non-Energy, has averaged 17% during 10MFY23 (assuming 60:40 Urban: Rural weight), and has followed a rising trend, bringing into question the efficacy of elevated interest rates in curbing inflationary pressures.
The picture becomes even grimmer when one looks at the trimmed CPI, which averaged 24.7%YoY so far this fiscal year. Is there a case for 25% interest rates? The high-base established in inflation readings this year (10MFY23 CPI inflation averaging 27.2%YoY and last three readings clocking in north of 30%) sets the stage for inflation tapering off in the latter half of FY24.
For instance, our estimates for 1HFY24 average inflation stand at ~25.5%YoY, which would taper off to ~16.2%YoY in 2HFY24 and average 20.8%YoY in FY24. Our inflation forecast incorporates further weakness in the PkR against the greenback, to the tune of 7% in FY24, and international commodity prices remaining elevated.
With these forecast in mind, 25% interest rates would be a disservice to the economy, with no real outcome. As earlier illustrated, rate hikes have failed to curb inflationary pressures in the case of Pakistan. A rate hike to 25% would correspond to a real positive interest rate of ~4-5ppt, based on our and seemingly the SBP’s estimates. Such a high interest rate environment would bring the already-challenging economic activity in the country to a halt.
Pakistan stuck in a deadly loop with the IMF: Recent statements by the IMF have pointed towards the resumption of Pakistan’s program being predicated on firm financing commitments from payment partners.
Pakistan has been able to gather the support from friendly countries, including the UAE and Saudi Arabia, for ~US$3bn—which has seemingly not been enough to satisfy the IMF. Reportedly, friendly countries are asking for the IMF’s nod as a prerequisite to committing funding options to Pakistan, which would unlock the resumption of the program.
Furthermore, Pakistan’s case has not been included in the agenda for the upcoming IMF Executive Board meeting, scheduled to be held on May 17, 2023, indicating further delays in the disbursement of the next tranche from the IMF program.
Investment perspective: In the event that the GOP succumbs to IMF’s latest (rumoured) demand, it would bring the economic activity in Pakistan to its knees. This may very well be the final nail in the coffin.
Heightened interest rates have already started to take a toll on the banking sector, with a majority of the sector reporting facing challenges in attracting Loan demand at current borrowing costs. For instance, BAFL management apprised that it saw a drop in Advances of ~5%QoQ due to termination of ongoing financing facilities as borrowing costs became difficult to meet.
From the vantage of capital markets, heightened interest rates are likely to lead to further accretion in participation in the equity markets, and cause flow of funds towards Fixed Income securities. On a broader level, heightened interest rates would also be detrimental to fiscal operations in the country, as has already been witnessed in 9MFY23.
MoF data reveals that PkR3.6tn were spent in mark-up payments in 9MFY23, corresponding to 54% of total Federal outlay during the period, and 52% of revenue generated. Increasing interest rates would further pressure the GoP’s costs.