Higher policy rate on the cards

ISLAMABAD: The State Bank of Pakistan was able to raise a total of Rs. 257.74 billion through T-Bill auctions, which happened on the 22nd of February. The target of collection for the said auction was supposed to be around Rs. 300 billion.

More importantly, the yield cut off for these T-bills happened to be close to 19.9%, which was 2.9% higher than the policy rate, and almost 2% higher than the previous yield cut offs. The policy rate stands at 17% as of the 23rd of February. 

Market implications hence, suggests that the effective rate is now above 19% and the State Bank might just announce a hike in a couple of days.

So why is there an increase in the interest rate? Why is there a need for such an increase and who will be affected by this decision?

Why do we need a higher rate?

A general understanding is that the IMF wants Pakistan to keep a higher policy rate. According to various news reports, the IMF has directly asked Pakistan to raise the central bank’s interest rate by 200 points. 

This raise will bring further slowdown in the economy, curbing the demand-side inflation. However, an even higher policy rate further stalls the already slowed down business activity. It also discourages more fiscal expenditures by the government, as it makes access to cash difficult. 

The two edged nature is the reason why Pakistan has held off on the policy rate increase until now. However, since the cap on the exchange rate has been removed and the taxes have been increased through a “mini-budget”. The inflation expectation is reported to be north of 30% for this quarter. This means yet another failure of the so-called inflation targeting monetary regime by the SBP. So what does the SBP do?

The CEO of topline securities and a Stock Market analyst, Muhammad Sohail, told Profit that because of a higher expected inflation, the increase in the t-bill rate, is a signal from the State Bank of a rate hike. 

It is important to note that, it is in fact the State Bank’s prerogative to keep the cutoff, in accordance with its monetary policy statement. The State Bank could have further strapped the government of cash, by cutting off the yield at its previous level. As per the bid report, that cut off would have raised less than Rs. 2 billion from the auction. 

Contrarily, the market expected a higher rate and the SBP obliged with a higher rate. The head of Research at Ismail Iqbal Securities, Fahad Rauf, told Reuters that the IMF has given a target to at least keep rates higher than core inflation. Pakistan has two core inflation readings i.e., Urban (15.4pc for Jan) and Rural (19.4pc) and no national core number is released. If the SBP tries to bring rates above rural core inflation, it requires a rate hike of 200-300 bps, he said. 

How do T-bill auctions work?

T-bills are short-term government securities that are issued by the government of Pakistan and distributed in the primary and secondary markets by the SBP. These highly liquid government securities have sovereign guarantees and a fixed rate of return, which is referred to as a yield. T-bills are a tool for raising short-term cash by governments.

Banks are allowed to hold this security in an Investor Portfolio of Securities (IPS) accounts for their customers. Investors can buy these securities in a competitive auction in the secondary market, or a non-competitive auction in the primary market.

On the day of the auction, primary dealers (banks and brokerage houses) offer bids for T-bills with a certain yield. This yield is determined by policy rates, market sentiment and future expectations. A certain cut-off for yield is announced that renders all the bids below that rate as accepted. The dealer then pays the SBP a discounted amount for the bill, which is returned in full at maturity factoring in the yield of the T-bills.