This post is written over iPhone. Apologies for typos.
My review of three years of Reza Baqir as SBP Governor made me realize that last year I was fixated with SBP Act amendment and the policy rate. My latest preoccupation is money market operations i.e., reverse repos (RRPs) and based on the prevailing economic circumstances, it appears RRPs and T-bill auction results may be the flavour of the substack for, at least, the next couple of months.
I had joked in the last post that former spokesperson for the former finance minister instead of falsely asserting that GoP is borrowing from SBP based on his misunderstanding of how the monetary statistics are reported, could have made a correct assertion if he had referred to SBP’s gradually increasing RRPs wherein SBP is lending to GoP through the back door and it has reached a historical high of Rs.3 trillion. Probably the spokesperson decided not to bring attention to this as it has been happening throughout the tenure of PTI (and even before that).
He has now been given another opportunity. Yesterday, SBP conducted a massive OMO ie Rs. 4.1 trillion of RRP at a cutoff of 12.3%. Rs. 3.5 trillion was for conventional OMO and Rs.0.5 trillion for sharia compliant. We are making new highs every month so saying historically high doesn’t make sense but a shrewd troll analyst/spokesperson can milk it for what’s it worth.
SBP appears to have lost control of the market. SBP’s efforts to bring down inflation by setting lower inflation expectations backfired as the only thing that took a hit as a result of that strategy was SBP’s credibility. SBP’s reactive policy with respect to setting the policy rate has ensured that the market deems the MPC as impotent, for now. Some of us used to eagerly look forward to MPS after the MPC not for any insight rather what pretzel logic MPC would give for the decisions it is taking. There was one MPC where the justification for decision was “vibes” (MPS used the word “feel”). Now RRPs appear to have become ineffective too.
Before the April policy rate increase, the difference between the RRP rate and 3M T-bill was 40-50bps. SBP was lending to the government through the commercial banks and allowing the commercial banks to make a spread of 40-50bps. That’s not the case anymore. The recent RRP was carried out at 12.3%. The 3M cut off of the previous auction was 14.8% thus allowing the banks a spread of 2.5%.
I haven’t checked it but I believe this must be a historically highest spread for risk free lending to GoP.
After losing control of inflation expectations and policy rate, has SBP also lost control of the back door lending to GoP?
In my earlier post about bank debt statistics I wrote
While commercial banks increased credit to the private sector in the last 3 years, they overdosed on investment in government securities during this period. The dashed line shows that while private sector borrowing as a percentage of the total was 46% at the beginning of the period, it reduced to 35% as of March 2022. Thus, private sector loans have come down from around half of the bank’s portfolio to a third of the bank’s portfolio. Or to put it in another way, banks’ investment in government securities is almost double the banks’ loans to the private sector.
Just the increase in commercial banks’ investment in government securities i.e., Rs.7.3 trillion, during this period is almost equal to the entire private sector loan outstanding i.e., Rs.7.8 trillion. This is despite the fact that SBP provided a stimulus of Rs. 2 trillion to the commercial banking sector for extending credit to the private sector.
I went on to say
We can establish two points:
Despite a very large stimulus including a reduction in the policy rate by 625bps, the increase in private-sector credit isn’t large compared to the increase in government borrowing. If Milton Friedman was right (I have my doubts) in saying that inflation is a monetary phenomenon, [it’s not the money supply to private sector that’s causing the inflation as the private sector received only 20% of the incremental money supply from the banks].
If inflation in Pakistan is money-supply induced inflation, we can safely conclude that government borrowing is the main culprit.
We know that under the present circumstances, the government sector has no capacity to reduce its borrowing, unlike the private sector. Any increase in interest rate will increase the financing cost of the government borrowing, resulting in the government printing more money to service this cost, thus further increasing the government borrowing. When the rate was increased to 9.75%, it was estimated that the financing cost of the government can increase by Rs.500 billion (yes, yes, I know, a part of it will come back to the government as tax revenue and the net impact may be less than Rs.500 billion). Now SBP has increased the rate by additional 250bps, and the federal government debt has also increased since the last estimate. It would be safe to estimate that the cumulative increase in the policy rate of 5.25% since September 2021 can increase the financing cost by Rs.1 trillion.
The above was written before the latest T-bill and PIB auction so we can safely assume that government’s share of borrowing will further increase.
Former finance minister tweeted this
Individual borrowers mainly avail two types of financing: housing finance and car finance. Housing finance is subsidized with rates fixed for 10 years so rising Kibor doesn’t affect the borrowing capacity of borrowers. Commercial banks themselves may cut back on lending due to risk off mode. With respect to car financing, I have already covered that despite trying almost every trick in the playbook, SBP failed to stop the car financing from taking off. If the increases in interest rate deters car financing, SBP should be happy. However, realistically speaking, the people who are availing car financing are doing it for store of value and investment properties of the cars and may not be discouraged by rising rates.
For businesses, if we take listed companies as a proxy for the companies that borrow from banks, they have made record profits. One would presume that they will have built sufficient buffers to withstand higher financing costs.
Aggregate numbers don’t tell the whole story. One has to look at disaggregated data. On ex-oil basis, the profits of the listed companies increased by 9% on average. 9% growth in profits may not provide as high as buffer as 34% but it does provide some protection.
The table doesn’t show the quality of earnings or cash flows. If the cash flows are stuck such as receivables circular debt of power sector, the earnings aren’t as rosy as they appear. To be noted, we are using the listed companies as a proxy of borrowing entities which may be far from accurate.
In the bank debt statistics post, I wrote
working capital is the only type of financing where…increase in interest rate can have any impact. I break down the working capital borrowing by industry type and look at the net increase month over month for different industries. The list isn’t comprehensive. I have selected only those industries where the change was significant.
The largest increase in working capital is from sugar, and it appears to be seasonal as six months earlier, the sugar industry was paying down its debt. The other big items are the manufacture of chemicals, fertilizers, and power generation. These aren’t the industries that you want to reduce the activity of or increase their cost of financing. If they reduce their borrowing, it will exacerbate the food supply or lead to power shutdowns. If they pass on their interest cost to end-users, it will lead to further inflation.
The aforementioned piece was written with respect to inflation i.e., increasing the interest rates will not reduce inflation rather exacerbate the situation. When interest rates rise and rise this rapidly, banks go into risk off mode. It will be “پہیہ جام” at I I Chundrigar Road. All the Seths that own the banks and the chief risk officers will be reassessing exposure to every industry and company. Credit limits would have been frozen.
While the companies may have built enough buffers due to higher profitability that they won’t default, but due to prevailing uncertainty, neither the companies will be looking to borrow more nor the banks will be willing to finance them. The growth in corporate credit will come to a halt and thereby affect private sector growth.
Let me reiterate: private sector borrowing is a small component of bank lending. Of the private sector borrowing, lending to SMEs only account for 20% of the borrowing. Most of the SMEs don’t borrow rather banks don’t lend to them. So rising interest rates will not affect them directly. However, if these SMEs supply to corporates that make use of the borrowings, then they will be affected as corporates may not order as much from the SMEs anymore.
To assess the impact of rising interest rates on growth, one needs to calculate what is the contribution of the following on the growth
Government borrowing
Consumer borrowing
Corporate borrowing
SME borrowing
SMEs that supply to entities that borrow
SMEs that aren’t included in 4 and 5.
There won’t be major affect on 1 and 6, a partial impact on 2 and a significant impact on 3, 4 and 5.
If I am to summarize this rambling post,
SBP is losing all control while banks are making a killing.
Corporates may have built enough buffers that there may not be widespread defaults due to increase in interest rates
The share of government borrowing will increase as a percentage of total bank lending
Borrowing by corporate and SMEs will decrease
The rising interest rates will not temper inflation
The growth will slow but the magnitude will depends on where the growth was coming from.