The central bank’s move to opt for a 150-basis-point increase in its key policy rate to contain rising inflation on the day the rupee fell 3.8 per cent has sent strong signals to financial markets and the International Monetary Fund (IMF).

Its short-term lending rate has now risen to 10pc from 8.5pc and will remain effective for the next two months. While announcing the rate, the SBP said inflation in 2018-19 might remain between 6.5pc and 7.5pc against the target of 6pc and economic growth would be slightly above 4pc.

How our new government will fulfil its promise of creating new jobs amid this economic growth prospect depends on its ability to enforce greater fiscal discipline on the one hand and improving external finance on the other. Without that, growth will not accelerate beyond 4pc, limiting the scope for job creation on a large scale.

A heavy dose of tightening had become necessary to take the policy rate into the double-digit zone. Allowing the rupee to fall to a new low shows that the State Bank of Pakistan (SBP) is serious in letting the local currency find its real worth.

An IMF mission told the authorities recently the rupee was still overvalued from the Fund’s point of view and monetary tightening undertaken before Nov 30 was less than sufficient for checking the growth in money supply.

The increase in banks’ lending rates will mean a higher cost of finance for many sub-sectors of the industry that are no more sitting on their own cash piles owing to smaller output growth

The Nov 30 increase in the policy rate preceded by the rupee’s fall to a new low of 139.06 to a dollar signalled to the financial markets that uncertainty about going to the IMF should end now.

These events indicate that political positioning and posturing aside, Pakistan is now serious in seeking a fresh IMF loan. Bankers say signalling this to the financial markets was necessary because Finance Minister Asad Umar’s statement in parliament that the government was in no hurry to obtain an IMF loan was adding to uncertainty.

In four and a half months of this fiscal year, there has been an unprecedented growth in private-sector lending by banks. Why? Actually the government was busy borrowing from the central bank (read printing money) to retire previous debts of commercial banks and to meet its current expenses. This means banks had no avenue to park excess liquidity except for lending to the private sector. And why was the private sector busy borrowing excessively from banks? They were doing so as they anticipated further interest rate tightening and knew well that banks had funds to lend.

“So the most immediate impact of the policy rate hike would be on banks’ private-sector lending,” says the treasurer of a large local bank. “Going forward, you will see a slower growth in credit than what you have seen so far.”

This is all the more possible because after heavily borrowing from the central bank and retiring commercial bank credit, the finance ministry will now switch gears: it will borrow more from banks to retire central bank debt. Banks will naturally rush for lending to the government.

That the interest rate hike has come at a time when large-scale manufacturing (LSM) is showing contraction is both good and bad. It is good in the sense that, with credit demand from the industrial sector already projected to slow down in coming months, tighter interest rates alone will not hurt growth sentiments the way they did in the presence of higher demand.

But it is bad in the sense that it might discourage even those sectors of LSM that are doing relatively well and could witness growth with some investment in production capacity building.

But monetary tightening is meant to discourage expansion and, by extension, investment for the time being and encourage savings for promoting local investment through local savings in the future.

The lagged impact of 275-percentage-point increase in the policy rate since January and other policy measures is likely to contain domestic demand during the current fiscal year, the SBP said in its monetary policy statement. Citing prospects of lower than last year’s output of major crops in 2018-19 and expected moderation in economic activity partly due to the contraction in LSM, the central bank has projected economic growth for the current fiscal year will be slightly above 4pc.

The output of LSM has recorded 1.71pc decline in the first three months of this fiscal year. Ten of the 15 LSM sectors, including textiles, food, fertilisers, automobiles and iron and steel manufacturing, have recorded negative growth.

Following the latest monetary tightening, the increase in banks’ lending rates means a higher cost of finance for such leading sectors of the industry that are no more sitting on their own cash piles due to smaller output growth.

On the other hand, higher bank interest rates will hurt even those five sectors of LSM that have so far shown a rising trend in production. These are electronics, leather products, paper and board, engineering products and rubber products. These sub- sectors of LSM are already in trouble due to a higher cost of imported inputs after the rupee depreciation.

Business leaders fear that the most telling impact of monetary tightening will be on small and medium enterprises (SMEs). They fear that with low economic growth, a weaker rupee and high interest rates, SMEs’ loan defaults will grow. And that, in turn, will discourage banks from lending to the SME sector, particularly if the government restarts borrowing from banks heavily. Between July 1 and Nov 16, the federal government retired Rs2.63 trillion worth of commercial banks’ credit by borrowing Rs2.99tr from the SBP for this purpose.

But once Pakistan enters the IMF programme, government borrowing from the SBP will have to be disciplined, senior bankers say.

Published in Dawn, The Business and Finance Weekly, December 3rd, 2018