Interest rate hikes force economy to slow down, corporate profits to erode and fresh investments to stall.

Rate hikes also make the inefficient and smaller companies to cut jobs, and sometimes shut down, as it becomes even tougher to service their debts.

In spite of ramifications of higher credit cost for the economic growth as well as the corporate profitability and viability, rate hikes are considered an effective response to inflation and inflationary expectations in an economy. But the business rarely agrees with central banks on the timing and quantum of the increase in credit cost.

The latest round of monetary tightening by the State Bank of Pakistan, which has raised its policy rate by two to 15 per cent in fourth hike since January, too has triggered strong criticism against the bank.

As interest rate peaks to its decade high level, some have termed the latest increase as the death knell for the manufacturing sector.

“This will have very serious ramifications for the industry and exports,” says Pervez Hanif, former president of Lahore Chamber of Commerce & Industry.

“Our debt burden and cost of servicing has increased, which could spawn defaults, closures, job cuts and poverty,” he argues.

For Nabeel Hashmi, an auto parts maker and exporter, the economic slowdown caused by tight monetary supply is too damaging for the manufacturing.

“The number of cars produced has dropped to around 3,000 units a day from 15,000 units. Auto vendors’ investment of Rs110 billion in capacity enhancement is totally wasted.”

He regrets that the central bank has failed to “think of any out-of-the-box solution” to curb the inflationary pressures and decided to put brakes on economic growth.

Leading stock broker, A.K. Dhedi, says the fresh hike will take away another Rs60 billion from the borrowers and give it to the rich bankers.

The latest rate hike by the central bank, battling inflation for more than two years, was being anticipated widely because of the weakening macroeconomic stability as demand pressures continued to mount and external current account and fiscal deficits expand.

Many feel the decision was made to meet International Monetary Fund (IMF) conditions for seeking balance-of-payments support as the country’s foreign-currency reserves deplete.

Businessman Amin Hashwani says the decision was taken under compulsion of the IMF

. He says the impact of the rate hike will be felt in 2009 and the business community should gear up for that. “The challenge requires that we add value to our exports and make our operations efficient and competitive,” he says.

SBP Governor Dr Shamshad Akhtar denies that the rate hike has anything to do with IMF and says the decision has been made to remove growing macroeconomic imbalances.

The surge in imports in spite of weakening global commodity prices, increased government borrowings from the SBP to finance its fiscal deficit and high inflationary pressures in the first four months to October this fiscal had led the bank to take the difficult decision, she argues.

While some analysts ‘doubt’ the rationale for the latest round of monetary tightening, others believe the bank should have made the decision earlier. “ Can we afford not to hike the rates? We are facing severe balance-of-payments crisis, which has led to sharp depreciation of the rupee in the recent weeks and intense pressures on the exchange rate. We have no option though it would cause unemployment and poverty to rise and dampen investment,” says Faisal Bari, who teaches economy at the Lahore University of Management Sciences.

There are many who question the wisdom of raising rates when the world is cutting credit cost to avoid recession.

But Bari argues that Pakistan’s crisis or troubles are different from the rest of the world where interest rates are being cut. “We are facing a foreign exchange crisis. We don’t have money to pay our foreign debt obligations. The rate cut in the given circumstances would harm the economy and the industry irreparably,” he insists.

Ali Cheema, who also teaches at LUMS, says those demanding rate cut are looking at exchange rate as a constant. “They aren’t taking the fact into account that import component of demand is up and exports are slowing. The objective of rate hike is to make balance-of-payments adjustments. The macroeconomic demand needs to be stabilised at a level where balance-of-payments problem does not arise,” Cheema says.

Businessmen, however, acknowledge that the central bank has taken some positive measures to minimise the negative impact of rate hike on the economy.

“It is good that central bank is more actively regulating commercial banks and injecting liquidity in the system whenever it is needed,” says Dhedi.

The central bank’s resolve to maintain the benchmark overnight rate -- KIBOR, at its current level of well below 16 per cent is widely appreciated. “If the SBP is able to effectively contain the KIBOR rate then the pain to the manufacturing sector will be limited,” says an analyst from AKD Securities.

But some like yarn exporter Akber Sheikh think that KIBOR must be abolished and SBP policy rate made the benchmark rate because of ability of some banks to manipulate inter-bank rate.

The SBP decision to provide 100 per cent export refinance and Long- Term Financing Facility for exporters is also hailed “because it will ensure smooth flow of credit to the industry and reduce liquidity constraints in the banking system”.

An analyst report says the “interest rate cycle has peaked with the latest hike in the policy rate. Considering that growth in monetary aggregates is slowing while commodity prices have plunged internationally, demand pressures and hence inflation and trade imbalances should decline in the coming months, a process likely to speed up in the second half of this fiscal. Therefore, we anticipate a reversal in the monetary stance by the end of the current fiscal year.”

Hashwani too advises the policy-makers to be “very mindful of not choking economic growth, and constantly revise interest rates as we enter the deflationary phase”.