Economic Challenges in Pakistan
The country’s financial capital is built through tight monetary and fiscal policies, where the real interest rate is kept high along with a primary budget surplus. But have you ever wondered how high real interest rates and primary surpluses affect the real economy?
Impact of High Real Interest Rates
High real interest rates on government debt encourage business firms to buy financial assets, such as treasury securities or equities, instead of investing in production. Many large business firms in Pakistan have invested their idle capital in the Pakistan Stock Exchange (PSX) or government bonds over the last couple of years. This shift in investment has significant consequences for the economy.
Reduced Investment in Production
High real interest rates reduce investment in capital goods and necessary raw materials, which in turn scales down production. As demand for goods and services remains intact, this reduction in production creates supply shortages. Furthermore, the high cost of borrowing for firms fuels cost-push inflation, especially when the central bank adopts inflation targeting.
Banking Sector’s Response
High real interest rates also encourage banks to invest in risk-free government bills and bonds. In Pakistan, banks have parked trillions of rupees in these government securities since 2008, reducing lending to business firms due to the risk involved. As a result, banks have been treading a safe path, looking for guaranteed returns and introducing fewer risky products for business firms.
Primary Surplus and Its Consequences
Primary surplus is achieved through tight fiscal policy, which means reducing expenditure and increasing tax revenue. However, fiscal tightening can lead to low income/GDP, ultimately lowering tax revenue. The lower income/GDP affects sales of business firms, reducing the rate of capacity utilization.
Impact on Business Firms
The lower sales affect the rate of capacity utilization, making it difficult for business firms to invest and expand. As a result, investment falls, and business firms curtail their operations. This signals to foreign investors that the country is not a suitable place for investment.
Foreign Direct Investment
Pakistan experienced its peak in foreign direct investment (FDI) in 2008, but since then, the level of FDI has been low. The only exception has been the power sector, where guaranteed returns attract foreigners to invest and get stable dollar returns. For instance, Yamaha motorcycles invested $150 million in 2015 but recently announced the closure of its operations due to declining sales and escalating production costs.
Conclusion
In conclusion, high real interest rates and primary surpluses lower the income/GDP growth rate, reducing tax collection. As most tax collection is through indirect means, the government has to increase tax rates and resort to new taxes under International Monetary Fund programs. These developments do not bode well for domestic and foreign investments, making the financial position of the country fragile and creating a challenging environment for industrial capitalists.
