The key admission the SBP governor made at her November 12 press conference was that “economic outcomes during the first four months of FY09 have deviated substantially from our expectations”.

She was referring to the three principal factors complicating economic management viz. increased public sector borrowing (Rs369 billion), imports (up by 35.2 per cent), and inflation (up by 25 per cent). She is right, but while adverse exchange rates and international prices did push up imports and inflation, public sector borrowing (triggered by current expenses) was controllable by the government.

In case of imports the tariffs weren’t raised on non-essentials as much as was possible, nor was the state muscle used to stamp out inflation to the extent it manifested price distortions rooted in market players’ greed. Except in the Punjab, we didn’t see the state isolating hoarders and holding them accountable.

What the government did catch (after erosion of market confidence) were the moneychangers. In this case too, a question mark hangs on the validity of its action given the strict law enacted in 1947, and confusions caused by its subsequent amendment through SROs in 1979, 1992, 1999, 2002 and 2003. That’s not all; according to the press, SRO 984 (I) issued in 2003 is untraceable even in the federal ministry of finance.

The fact that the outcomes of regulatory action “deviated substantially” from SBP’s expectations reflects on the vision of the key market regulator, and lack of support to it from the state in crystallising the desired outcomes. This isn’t the combination that inspires confidence in the administrative capacity of the state, especially in the backdrop of the challenges the country faces.

It also explains why the ‘Friends of Pakistan’ are not keen on lending to Pakistan until it agrees to strict monitoring by the IMF although little can be said about IMF’s vision when viewed in the backdrop of the archaic restrictions it has grown accustomed to imposing on the borrower countries; French president Nicholas Sarkozy has commented on this aspect better (and more harshly) than anyone else.

The parameters within which Pakistan negotiated a bailout package with IMF weren’t disclosed.

Press reports indicated that the IMF had sought a 3.5 per cent hike in SBP discount rate, and besides the two per cent now, a further 1.5 per cent hike is expected in January 2009. While IMF has been blamed for a hike in interest rates, by their own conduct banks provided IMF the justification for seeking a rate hike.

We all (including SBP) were witness to the fact that the 6-month KIBOR was consistently above the SBP discount rate by nearly 2.5 per cent although, as in most economies, KIBOR should have been fractionally below, not above the discount rate. This banks-created distortion provided the justification for a rate hike, and the recent SBP warnings to banks to desist from raising lending rates.

The distorted KIBOR reflected pressures to ration credit following huge deposit withdrawals (Rs. 232 billion), build up of slow moving loans, and no appetite in inter-bank market for clean lending. Although, after October 11, cuts in CRR and increase in SBP’s share in export re-finance injected Rs360 billion into the system, this amount is close to just the slow-moving consumer loans, not the others.

Banks’ response to this scenario exhibited a yearning for large deposits, which won’t work. Even the big five, with networks in small towns haven’t come up with aggressive campaigns to retrieve saving deposits although money in circulation is at a record high. Unless that wealth idling in homes and shops is sucked back into the system, liquidity squeeze will force credit rationing using higher lending rates.

It is important that banks heed the SBP warning against raising lending rates because the cost of deposits (except in smaller banks) rose sharply only in recent weeks. Interest rate spreads earned by banks until June 2008, were as high as before. The accumulated earnings leave room for holding lending rates steady without losing out too much. But that implies accepting realities and prioritising survival over profit.

A top-ranking banker admitted the urgent need for banks to live with lower profits until they resurrected the shrinking industrial sector but he wasn’t sure whether banks’ boards of directors would appreciate the need for this strategy. Vision, unfortunately, is in short supply and this problem is pervasive. Thus, hoping that banks will, for once, prioritise economic stability over profit, seems optimistic.

Given this psyche of the bank owners and managers, that has been allowed to flourish in the name of de-regulation, was it appropriate for the SBP to increase its discount rate? The answer lies in its ability now to check a rise in banking lending rates. That is a tough ask considering the fact that it discovered only in late 2007 the malpractices banks were indulging in while re-pricing floating mark-up rates.

While the SBP insists (incorrectly) that financing costs amount to just three per cent of the total cost of doing business, it does admit that labour, material and operating costs account for the other 97 per cent. With inflation still rising at more than 25 per cent a month, won’t the rising labour costs at first eat into business profitability and then steadily paralyse the industry causing huge labour layoffs?

Higher lending rates have already squeezed the documented businesses because they tend to be over-leveraged; as interest rates rise, their financing costs overshoot the mythical three per cent of their total cost. In the competitive setting during a recession, even a slight hike in lending rates proves lethal. If that happens, banks would be the losers because the development will limit lending to the less risky documented sector.

SBP also (roundly) admits that, with sectors influencing prices of food and essentials still undocumented, earlier interest rate hikes failed to lower the CPI. But, the two per cent hike in the discount rate (giving bank a reason to follow suit) could make credit more expensive for the documented sector that also pays taxes. A contracting documented sector could freeze the tax-GDP ratio where it is.

Besides tax revenue loss, which will prevent cutting the huge fiscal deficit, it foretells another adverse outcome: demands for higher wages and salaries as the CPI rises because, while unaffected by rate rises, the undocumented sector touts them to justify price escalation.

Can we cut the entire PSDP? What about projects without which the infrastructure gaps will keep squeezing growth? If inflation (that determines a currency’s value versus another) doesn’t drop, how can the rupee’s exchange value be strengthened to assure cheaper imports for both the domestic market as well as for the export industries?