In mid-September auction of treasury bills, the government rejected all bids for short-term borrowing as banks were demanding interest rates of 17% or higher. By early October, banks had lowered their offers to around 14%, but the government chose to exercise more caution and rejected all offers for three-month treasury bills. In just two auction sessions where the government refrained from borrowing, commercial banks found themselves in a tough spot. For instance, Habib Bank alone is sitting on 2 trillion rupees but lacks any major clients to lend to in order to earn interest.
This rapid shift demonstrated that the arrogance of the banks was contingent on government borrowing. As soon as the government temporarily halted borrowing from commercial banks, the banks’ posture crumbled. Now, these banks are scrambling to find private clients, but there is a glaring shortage of borrowers. Smart borrowers are aware that further reductions in interest rates are likely, so they are holding off on taking out loans. On the other hand, banks had historically been providing the bulk of their loans for car financing. However, in a surprising shift, car manufacturers have started offering installment plans themselves, and some are even offering interest-free financing. This has left the banks in a bind, with hundreds of billions of rupees sitting unused.
Before December, the government needs to repay some loans, which will require taking on new debt. In theory, the government could have opted to borrow solely from the State Bank for a few months and sidelined the private commercial banks. However, recent legislation has declared borrowing from the State Bank to be forbidden, a move that was made to satisfy international monetary institutions. Meanwhile, watchdogs from the International Monetary Fund (IMF), led by figures like Geeta Gopinath, are keeping a very close eye on these transactions. As a result, borrowing from the State Bank is no longer a viable option. However, the government still has the opportunity to adopt a minimal borrowing policy for some time, which could significantly influence market dynamics.
If the government were to exercise prudence and limit borrowing to only the most essential needs, interest rates could potentially drop to single digits before the end of December. This would provide significant relief to both businesses and consumers alike. However, the government’s finance minister is a former banker, and the question arises: how far will he go in curtailing his former industry? Will the government prioritize long-term economic stability over short-term gains for the banking sector?
Currently, banks are flush with liquidity, with enormous sums of money sitting idle. This abundance of funds is not necessarily a good thing for the banks. On top of this, they face the looming threat of penalties from the State Bank. If a bank’s advance-to-deposit ratio falls below a certain threshold, the State Bank can impose hefty fines. However, the problem for the banks is that there is currently a dearth of borrowers – nobody is willing to take on loans at the high interest rates currently being offered.
If the government continues to refrain from borrowing from commercial banks for the next two months, it is highly likely that banks will be forced to lower their rates in order to attract borrowers. In fact, it’s quite possible that banks could start offering loans at rates as low as 8%, begging clients to borrow money. However, this strategy is not without risks. Extremely low-interest loans could potentially encourage people to make unnecessary luxury purchases. If that happens, the country’s imports would rise sharply, leading to an increased burden on the foreign exchange reserves and putting pressure on the value of the rupee. A significant depreciation of the rupee could, in turn, lead to another wave of inflation. Therefore, while low-interest rates can stimulate borrowing, they also carry the risk of overheating the economy and increasing the trade deficit.
In light of these risks, the State Bank of Pakistan will need to act wisely and make judicious use of its regulatory powers. One effective approach would be for the State Bank to issue prudential regulations for commercial banks, guiding them on how to allocate their loans. My recommendation is that the State Bank should instruct commercial banks to limit consumer loans to no more than 15% of their total loan portfolio. Additionally, the minimum interest rate on these consumer loans should be KIBOR + 8%. This would prevent an excessive rise in consumer borrowing for luxury goods, which could contribute to inflation and strain foreign reserves through increased imports.
For business loans, the State Bank could issue guidelines stating that the interest rate on such loans should not exceed KIBOR + 4%, and that at least 30% of the bank’s total loan portfolio must be allocated to business loans. By prioritizing business loans over consumer loans, the State Bank could encourage increased investment in productive sectors of the economy, which would lead to greater supply of goods and services. An increase in supply could help alleviate inflationary pressures, as greater availability of goods would reduce upward pressure on prices.
The current economic climate requires decisive action. The government must minimize its borrowing from commercial banks so that these banks are forced to lend to the private sector. At the same time, the State Bank should ease the process of borrowing for businesses by making business loans more accessible. If the government adopts such measures, it is entirely possible that the interest payments on domestic debt for the current fiscal year could be reduced from 8,700 billion rupees to 7,000 billion rupees. Furthermore, inflation could stabilize within a range of 5% to 7%, creating a more favorable environment for economic growth.
However, if the government fails to act responsibly and continues with heavy borrowing, the banks’ business will once again flourish at the expense of the public. In such a scenario, interest rates will remain high, inflationary pressures will continue, and the public will bear the brunt of the economic burden through increased prices and limited access to affordable credit. The government’s decision to borrow prudently – or to borrow heavily – will determine whether the economy stabilizes or whether the difficulties faced by the public are prolonged.
The choices made in the coming months will have lasting consequences. By carefully managing debt and encouraging productive investment in the private sector, the government can navigate these economic challenges and create a more sustainable future for the country. Conversely, failure to take the necessary steps could result in continued inflation, higher debt servicing costs, and greater economic hardship for the general population.
