Paradox of investments and rates

The investment decisions of Pakistan’s private sector, led by a few large family-owned business groups, are influenced by a myriad of factors. While the interest rate may be a consideration, historical evidence suggests it’s not necessarily the key determinant shaping investment trajectories in the country.

All other factors are excluded here to gain a better insight into the relationship between the interest rate and investment. Over the last five years, the interest rate has more than doubled since May 2019, when it was 10.7 per cent, and tripled since June 2020, rising from 7pc to the current 22pc.

Surprisingly, despite this significant increase, the investment-to-GDP rate has not crashed — it has only fallen by a modest 2.4pc, from 15.7pc in May 2019 to 13.3pc currently, according to official data.

In a nation of 240 million, plagued by a succession of crises and faced by the looming threat of public discontent erupting into the streets, the issue at hand is pertinent enough to warrant systematic research efforts. Such endeavours may aim to inform evidence-based policy interventions geared towards stimulating investment and unlocking the country’s economic potential.

Despite a significant rise in interest rate to 22pc, investment-to-GDP fell by only 2.4pc, highlighting a curious relationship between the two factors

At first glance, factors such as global investment climate (adversely impacted by the pandemic in the period under review), political instability, erratic economic policies, prioritisation of resource mobilisation over investment needs, excessive government interference in business affairs and security concerns have all cast a shadow on investment sentiments.

In addition to the well-known factors mentioned above, often highlighted by business bodies, the intriguing relationship between interest rates and investment in Pakistan sheds light on certain unique aspects of the country’s ground realities. It’s difficult to dismiss the possibility of access to substantial amounts of unaccounted funds circulating within the economy finding their way to the investor class in Pakistan.

In private conversations, numerous top businessmen have confessed to maintaining multiple accounting books, revealing that their recorded activities represent only a fraction of their actual business scale. They justify this practice by citing examples of misguided, wasteful public spending and argue that their hidden wealth is utilised effectively and efficiently in private endeavours.

Another important factor that emerged during background research was faith-related. Some affluent oligarchs disclosed that they avoid the banking system due to religious beliefs prohibiting interest (Riba).

In response to a request for comments on the anomaly under discussion, some prominent tycoons and business executives defended their class while advocating for the State Bank to revise its interest rate downward.

Muhammad Ali Tabba, CEO of Lucky Group, refrained from commenting on the issue raised and instead offered a note of cautious optimism. “It all depends on the investment policy. In an investment-friendly environment with competitive energy prices, I am pretty confident that investment will begin to flow again,” he remarked.

Gohar Eijaz, a prominent channel owner, property developer, leader of the All Pakistan Textile Mills Association, and former caretaker federal minister for commerce, industry, production, and interior, shared a detailed response sidelining the debate. He noted that high inflation rates have historically compelled the SBP to maintain elevated policy rates.

He highlighted, “The government is the biggest bank borrower in Pakistan, with over 70pc of public savings invested in government bonds, while less than 20pc is borrowed by the private sector, mainly for working capital.

“In a country where high interest rates are used to manage cost-push inflation, it often results in substantial fiscal deficits and productivity loss in the private sector. However, the situation is improving, with inflation now falling due to stable currency, improved macroeconomic conditions, zero current account deficit, a 10pc increase in exports, and a 38pc devaluation in the past two years.

“Increased market demand has spurred production. To lower interest rates, the initial focus should be on reviving growth by optimising existing capacity and encouraging new investments.”

Nasim Beg, CEO of Arif Habib Consultancy and a seasoned executive on multiple company boards, noted, “Historically, the total return on equity investment in Pakistan has averaged around 20pc. During periods of single-digit interest rates, many businesses invested in capital expenditure [capex] using a mix of debt and equity [typically a 70:30 debt-to-equity ratio]. Therefore, with rates around 10pc, borrowing was considered beneficial for businesses.

“The high interest rates have several adverse effects, such as businesses that borrowed long-term funds for capital expenditure being severely affected — since long-term borrowing is on floating rates — undermining the feasibility of the incurred cost. The cost-carrying inventory rises due to expensive working capital borrowing, while high interest rates divert investible capital towards debt instruments from equity investment.

“Furthermore, hiring to support growth stagnates, leading to higher unemployment and lower per capita purchasing power, fueling a vicious cycle. High interest rates also inversely impact stocks’ price-earning (PE) ratios, resulting in lower PEs. This forces businesses to sell stocks cheaply to attract growth capital, exacerbating the negative cycle. Finally, leveraged buyers in the equity market shy away from leveraging at high rates, dampening market activity.”

Published in Dawn, The Business and Finance Weekly, May 13th, 2024