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If the SBP raises its discount rate, will it bode well for bank gains?

Will raising discount rates hike bank gains further? And how far will it check inflation?

These are two questions with which the government, central and commercial bankers, and the financial sector are engrossed in these days, in run up to the new monetary policy and the benchmark discount rate to be announced at the end of this month.

These questions have come up on the back of the current negotiations with the IMF for release of a $1.7 tranche of a $11.6 billion Stand-By Agreement, the ongoing slowdown of the economy, slashing down of the GDP rate for current FY-2011. All this comes in the wake of the flood devastation, and already spiralling inflation.

The State Bank of Pakistan, or SBP, has adopted a tight monetary policy for the last three years in its bid to control inflation. But it has failed. Inflation which was projected to brought down to 9.5 per cent in FY-2011, from close to 13 per cent last year, is now projected by the SBP at 13.5-14.5 per cent for FY-2011.

A fifth month into FY-2011, the headline inflation is officially calculated by the Federal Bureau of Statistics at 16.38 per cent year-on-year, while food inflation is raging at 21.5 per cent, and rising. This inflationary spiral is continuing on the back of higher prices of food, petroleum products, and electricity. Heavy government borrowing from the SBP to fill the budget deficit is also a major cause fuelling inflation. The government needs cash to meet military spending on the war against terrorism.

The ongoing inflationary pressure, may force the SBP to hike the benchmark discount rate by 50 basis points to 14 per cent, in the upcoming monetary policy to be effective on December 1. “Given the SBP fixation with real interest rates, we expect a further hike of at least 50 basis points in the upcoming monetary policy statement” for two months in December and January, said Ayub Ansari, an analyst at Invest and Finance Securities forecasts.

The discount rate was raised by 50 basis points from 13 to 13.50 on September 30 for the October 1 to November 30 period as part of the tight monetary policy. But it again failed to stem the inflationary tide.

During the recent talks, the IMF has reportedly agreed to allow the government to let inflation rise to 15 per cent, from the earlier projection of 13 per cent. While several key economic indicators are negative, the banks are doing fairly well. The profitability of commercial banks, in nine months to September 30 of CY-2010, rose 11 per cent to Rs50.2 billion, up from Rs45 billion in the same period of CY-2009.

Profits were largely shared by the Big-Five banks which picked up 98 per cent of the overall profit amount, up from 96 per cent share in CY-2009. Small and medium-sized banks are not earning enough profit to flourish and invest in their own capacity building. Will it lead to more mergers and acquisitions as what had happened in the recent past? “The increase in profitability can be attributed to an eight per cent rise in the net interest income, led by a 7.5 per cent hike in the interest earned along with a massive 23 per cent decline in the provisioning for non-performing loans, registered by the banking sector, due to higher provisioning last year. There is an increasing preference for banks towards risk-free investment as opposed to advances,” said Muniba Saeed, an analyst at Invest Capital. But this can negatively impact the returns on earning assets of the banks.

Looking at banks’ performance, one also comes to the conclusion that the ratio of non-performing loans to advances is low in the case of banks which have effective risk-management. These banks have a lesser number of infected loans, better portfolio of advances, and better average recovery rate than others.

The huge profit sweep of the profits by the Big-Five, raises several questions. Is the banking system moving towards cartelisation, despite their already having “captive clients?” The National Bank of Pakistan, for instance, already has the huge business of the government, government organisations, and employees.

The good performance by banks also raises some questions about the quality of their operations. When non-interest income, or NII, is declining and NII-expenses are rising one has to consider whether the banks are investing in their own capacity building? It includes elements like provision of legal documentation and consultancy, property valuation, money transfer, providing lockers, and several other customer-friendly services. Another question is, as NII is rising and banking system is dominated by a small group, does it mean that some cartelisation is going on and the number of “captive clients of those particular banks is increasing?”

But whatever the SBP is planning to introduce in the upcoming monetary policy, it should keep in view both the interests of business growth and consumers so that the economy moves ahead, supply-side situation improves, the cost of consumer goods declines and inflation is checked. A discount rate hike will raise bank profits, that’s for sure. Lots of conflicting objectives? But that is the art of the central bank to watch stakeholders’, and more so, the peoples interest. Will the SBP gel things together?

Views expressed by the author are his own and do not reflect the newspaper’s policy.