AROUND two weeks back, the central bank cut the benchmark interest rate by 50 basis points to 6pc. And in the immediate aftermath, corporate Pakistan and the capital market barely reacted to the development.

On the first day of trading after the State Bank of Pakistan (SBP) announced the rate cut (September 14), the KSE-100 index dropped 287.99 points, with trading volumes declining to 16-week lows. Since then, the index has fallen by another 558 points (till last Monday).

While this has been attributed to various developments — the most prominent of them being investigations into some local brokers by the SECP and NAB — it appears that the power of policy rate cuts to drive investor sentiments has lost a bit of its charm in the country.

Since November 2014, the SBP has reduced the policy rate by a sizable 400bps, from 10pc to 6pc.

“Despite the policy rate declining, the response from the market has been muted. This [can be] attributed to a lack of enthusiasm and liquidity in the market on account of: heightened call of risk management, rumours of broker investigations by NAB, and selling by foreigners over the last few months,” remarked Taha Khan Javed, head of research at Elixir Securities.

Some areas where declining interest rates should have had an impact, at least theoretically, have actually appeared seemingly immune from them.

Impact on banks: The banks have taken various steps to minimise the impact of policy rate cuts on their earnings, laying waste to the argument that lower yields on government debt will force them to seek better returns offered by loans.

When the monetary easing cycle set in, sector watchers nearly unanimously asserted that the profitability of the banking sector will be hit hard.

That has yet to happen. Banks’ cumulative pre-tax profits for January-June (1HCY15) amounted to Rs171bn — up from Rs113bn in the corresponding period last year (before interest rates had begun declining).

In fact, the banks’ pre-tax profit for 1HCY15 is over 69pc of what they had earned in the entire calendar year 2014 (Rs247bn).

Some areas where declining interest rates should have had an impact, at least theoretically, have appeared seemingly immune from them

One reason for this is that the banks, particularly the larger ones, have lengthened the maturity profile of their Pakistan Investment Bond (PIB) holdings.

As coupon rates on freshly issued bonds has gone down during this period — the cut-off yield on five-year PIBs issued in October 2014 was 12.9646pc, against 8.2431pc for those of the same tenure issued earlier this month — the banks have locked in higher yields on the longer-term bonds.

While “low and declining interest rates have negatively pressured banks’ spreads (i.e. the difference between the weighted average lending and deposit rates), PIB yields have so far remained profitable, with a systemwide return on assets of 1.6pc in the first half of the year,” said a report issued by credit rating firm Moody’s last week.

“The shift to long-term PIBs has supported banks’ net interest margins, although systemwide spreads were 550bps in July, versus 620bps November 2013,” it added.

However, this was at least partly due to the introduction of a ‘target rate’ within an ‘interest rate corridor’ by the central bank in May, which squeezed banks’ margins from both the lending and deposit sides.

It remains to be seen whether banks will change their modus operandi next year, when the first batch of high-yield PIBs will start maturing. It is also uncertain at this point if the incentives for them have realigned to the extent that they will opt for fresh lending or be comfortable with relatively low-yielding government debt securities.

Private-sector lending: Meanwhile, despite the cumulative 350bps rate cut during FY15, net credit disbursement to the private sector stood at Rs208.7bn, down from Rs371.4bn in FY14.

Bankers’ response to criticism that they prefer to park whatever scare liquidity they have into government debt is well-known by now. They point to muted demand for credit from businesses, which, they say, are sitting with excess capacity owing to power outages and high costs.

They also rope in the phrase ‘law and order situation’ in their explanations, reasoning that this casts a pall on investor sentiments, dulls general economic activity and leads to subdued loan demand.

However, some of them admit privately that while there is some credit demand, even from blue chip companies, these firms demand rates that are so low that it is simply not feasible for banks to lend at such risk-adjusted margins to them.

Besides, many of the big companies are sitting on piles of cash and some choose to self-finance their working as well as project capital requirements instead of opting for bank loans.

The ultimate beneficiary: All of this brings one to ask about the ultimate beneficiary of the rate cuts.

Since the almost year-long cycle of monetary easing has neither stimulated private-sector lending — and, by extension, economic activity in general and large-scale manufacturing in particular — nor impacted banks’ profits, one is left to wonder if the low inflation — the central bank’s principal justification for rate cuts — alone warrants such a policy.

Enter the government. The stock of outstanding PIBs by May had ballooned to Rs4.1tr, from Rs1.3tr at end-June 2013. And the lowering of interest rates had a visible impact on the government’s cost of debt servicing, which fell 4.9pc to over Rs1.7tr in FY15, according to provisional SBP data.

Taurus Securities’ head of research, Zeeshan Afzal, referred to the all-round borrowing cycle that is behind the seemingly unfeasible status quo.

“The government needs to borrow money and it can’t get the SBP to go overboard with the printing press with the IMF perched over its shoulder.

“So it turns to banks. And the banks — which are already liquidity-starved — utilise the central bank’s open market injections to get funds and then lend them to the government.”

Published in Dawn, Business & Finance weekly, September 28th, 2015

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