Remember the State Bank of Pakistan’s (SBP) 17th December Open Market Operation (OMO)? In that OMO, the SBP had injected into the interbank money market a colossal sum of Rs1.77 trillion. This OMO was the largest ever in terms of the funds injected and was also unique in that the central bank provided liquidity to banks not just for a week or two — but for 63 days for the first time ever.

In diplomatic jargon, this was a confidence-building measure (CBM). The SBP has since taken several CBMs to signal to the banks that as it takes progressive steps towards “inflation-targeting”, they must not try to manipulate interest rates.

The “sovereignty-sensitive” SBP Amendment Bill 2021 has been passed by the National Assembly (NA) or the lower house of the parliament and its approval from the Senate shouldn’t be an issue given that Pakistan is under immense pressure from the International Monetary Fund to make SBP more autonomous. Prior to the NA approval of the Bill that seeks sweeping powers for the central bank, the SBP was in the process of making inflation-targeting the anchor of its monetary policy. For quite some time its monetary policy has remained geared more towards checking inflation rather than achieving the three-pronged objective of promoting economic growth, containing inflation and maintaining the financial sector’s stability — all at the same time.

Improved liquidity management will eventually help the central bank prepare grounds for pursuing inflation targeting forcefully in the medium term — in the short term, however, it has provided some comfort to the government and the private sector

SBP will now have to manage interbank money and forex markets most effectively — leaving no room for the banks to impede the orderly and timely transmission of monetary policy signals through interest rate manipulation.

Lack of such efficiency on SBP’s part would mean keeping some room available for banks and other financial institutions to manipulate interest rates on the excuse of liquidity crunch or liquidity overflow. In that case, the central bank would not be able to continue with inflation targeting wholeheartedly — and with full force.

This explains why the SBP injected unprecedentedly huge liquidity —and part of it for as long as 63 days instead of three days, a week or two weeks — in its 17th December OMO. Injection of Rs1.77tr through that OMO made banks realise the folly of what they were doing. Immediately after 14th December interest rate tightening, almost all of them had pushed yields on the government T-bills and bonds beyond the normal range. Had the SBP not corrected their attitude by pumping in extra-large liquidity in the money market, interest rates for bank borrowers — tied to the yields on T-bills and bonds — would have risen to the levels not originally intended by the SBP.

The SBP intervention brought sanity to the market and the yields fell closer to where the SBP wanted them to be after a 100 basis points increase in its policy rate announced on December 14. And that is why the SBP has conducted more OMOs after that in which it has injected enough liquidity into the market in different shorter tenues — as well as for 63 days.

This improved liquidity management will eventually help the SBP prepare grounds for pursuing inflation targeting forcefully in the medium term. In the short term, however, it has provided some comfort to the government and the private sector.

In 1HFY22 (July-Dec 2021), the federal government borrowed Rs353 billion from banks against more than Rs1.032tr in the same period of the last year. The private sector’s bank borrowing crossed the Rs1.014tr mark in 1HFY22 against that of only Rs344bn in the year-ago period, the latest SBP stats reveal.

By injecting enough liquidity in the money market, the SBP wants to ensure that on scheduled dates of the auctions of government treasury bills and bonds, banks do not demand unjustifiably high rates of return, making fresh government borrowing from them all the more costly. A 150bps rise in the SBP policy rate announced on 21st November followed by another of 100bps on 14th December has already inflated the government’s cost of domestic debt servicing. The federal government plans to make huge fresh borrowings from banks and rollover earlier debts between Jan-June 2022. But it cannot afford to pay them unreasonably high-interest rates.

In the 29th December auction of T-bills, the weighted average yield on the six-month paper soared to 11.32pc — 157 basis points higher than the SBP’s policy rate of 9.75pc. In the following auction held on Jan 12, the weighted average yield on six-month debt papers remained stubbornly high at 11.34pc. This means that the availability of enough liquidity in the money market may not necessarily compel banks to bring the spread between the SBP policy rate and the rates at which they want to invest in T-bills.

Had the SBP not started injecting huge funds into the money market, banks could have built their strategy for lending the government at even higher rates 200bps or more above the SBP’s policy rate. And that would have made it extremely difficult for the government to make fresh borrowings from banks.

In the absence of liquidity injection by the SBP, banks could also have taken advantage of a tight money market for making their private sector loans prohibitively pricier. (Six-month T-bills rate serve as a floor for most of the private sector loans. Premiums are charged according to the creditworthiness of borrowers).

That could have suppressed the private sector’s credit demand beyond the extent that the SBP’s double dose of monetary tightening aimed at containing double-digit inflation (12.3pc year-on-year in December).

So far the SBP’s interest rate management apparently has some pro-growth bias. But going forward, things may change dramatically. Let’s see.

Published in Dawn, The Business and Finance Weekly, January 17th, 2022