Capital gains tax, high interest rates and uncertainty

BRISTOL: This is how the story goes! With capital gains tax in place, profitability will decrease and therefore much needed investment from both within and abroad will not flow into the capital market. Instead it may even force existing investors to withdraw their investments from the country’s stock exchange.

With capital outflow, growth will decrease and much needed jobs will not be created leaving the country worse-off as a whole. As such restrictions on capital flows will affect investors’ confidence in the national economy; chances of future investment will decrease hence putting country’s future growth at stake as well.

With capital flows taking such an important role, one may ask what else can be done to increase such inflows? Ask any IMF official and the answer will be to increase interest rates. It serves two purposes. Firstly, an increase in interest rates decreases domestic demand and therefore inflation by making it more attractive for people to save more. Secondly, it increases the rate of return for foreign investors who are now more likely to take the required risk and bring their money into the domestic economy which also helps in stabilising the exchange rate. Makes sense, right?

Such free inflow of capital (money) is as good for short term stability as it is for instability, with close to no benefit for long term growth of country’s GDP. Capital flows are pro-cyclical. Investors enter the market during the high growth periods to make quick money and leave when the situation deteriorates. To be more precise, ‘hot money’ enters the economy when it is least needed therefore exacerbating the inflationary pressure and leaves when it is most needed hence pushing the economy further into recession.

When the East Asia crisis hit Thailand – which had liberalised its capital market as per IMF’s advice, a complete reversal of investors’ sentiment resulted in huge outflows which amounted to 7.9% of GDP in 1997, 12.3% in 1998 and 7% in the first half of 1999. The only country to stand up to the dictates of the IMF during the East Asia crisis was Malaysia. Their policies of putting breaks to the free flow of capital (or speculative capital which is a consequence of such a policy) and not increasing the interest rates paid off as Malaysia experienced the shorter and shallower downturn relative to other countries.

Interest rates are a useful tool to control inflation, given that the reason for inflation is excess demand. However, inflation in Pakistan has been largely due to global commodity prices and supply side constraints in both agriculture (floods) and manufacturing (energy shortages). With growth rates for last couple of years already at low levels, it is unlikely that excess demand is the cause for double digit inflation.

In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. In Pakistan not even a fraction of businesses are listed on the stock exchange. Under an environment with high interest rates, likelihood of default increases for businesses as they are now required to pay huge amounts to their creditors (banks).

Apart from low growth rate, uncertainty at both political and security front makes it even more difficult to attract both local and international investors to Pakistan. In the case of East Asia, high interest rates, free capital flows and everything which the IMF says did not succeed in achieving the desired results.

Two main things which come out of this discussion are imposition of capital gains tax and lowering of interest rates. In addition corporate tax should also be lowered to compensate domestic businesses for the uncertainty. While capital gains tax will bring much needed stability to the capital markets, low interest rates and decrease in corporate tax will provide much needed breathing space to businesses so they can increase their production and expand further thereby overcoming the supply side constraints to some extent. The magnitude of the change is an empirical question and should better be left to those who have access to the data.

First Published in Tribune (23rd April 2012)

http://tribune.com.pk/story/368377/capital-gains-tax-high-interest-rates-and-uncertainty/

Tracking inflation for optimal monetary policy

IN an economy inflation is often considered a monetary phenomenon which can be appropriately dealt with by using interest rates as a policy tool.

Researchers have also suggested and shown that in a general case increasing nominal interest rates by more than one unit for a unit increase in inflation produces reasonably good outcomes on average.

However, the simplicity of such rules often requires that a policymaker be aware of the underlying variables and be mindful of the judgement required on his part.

Fortunately, much more flexible models have evolved which consider variety of factors before suggesting a policy response.

One essential feature of these is the taking into account of various uncertainties or shocks (such as demand and cost shocks) which the economy experiences from time to time.

This brings us to an important step of investigating these shocks in the data followed by reconciling them with the observable events and then proposing a policy framework which may be most appropriate. Here I make a similar attempt in the case of Pakistan.

I have chosen 2008 as my starting year because it is then when international commodity prices touched their peak which was later followed by the global financial crisis. Furthermore, the data from the State Bank shows that inflation in Pakistan started increasing around January 2008 – few months after international oil prices started rising.

A detailed look at the data shows that initially commodity price shock and removal of subsidies led to an increase in food and fuel prices while the non food non energy (NFNE) group inflation did not change by much.

Gradually, with a lag of one quarter (roughly), NFNE inflation increased (due to rising marginal cost) up to 18.9 per cent in January 2009. By this time food and fuel inflation had already started declining from its peak of more than 25 per cent and had come down to around 21 per cent. Keeping in mind the earlier lag effect, NFNE inflation started declining from February 2009 onwards. In 2010 floods came and food inflation shot back up to 20 per cent while the NFNE inflation remained stable. With the
effect of floods subsiding, inflation declined subsequently.

From 13.9 per cent in Jan 2011 to 10.1 per cent in Jan 2012, year- on- year inflation has declined further. Much of the decline in the later year can be attributed to decrease in inflation for the food group (from 20.2 to 9.2 per cent over the same period) due to better crop production and sufficient levels of buffer stock. Considerable decline is also due to fall in the global food prices which saw an year-on-year increase of 29.9 per cent in January 2011 but declined by 10.7 per cent in January 2012.

Most of the fluctuations in various inflation indexes can be traced back either to the global trends in commodity prices or domestic shocks such as due to floods, energy shortages or elimination of subsidies. Other shocks are also in the form of government increasing the minimum price of major crops (such as wheat) which consequently lead to increase in prices of other crops as well. Owing to this uncertainty which underlay these events, the optimal monetary response should therefore be a cautionary one. Any attempt to aggressively reduce fluctuations in inflation under the given scenario will push the level of output further below its natural level and therefore reduce the overall social welfare.

In developing countries where equity markets are by and large underdeveloped, businesses rely on loans to expand and run themselves. In Pakistan not even a fraction of businesses are listed on the stock exchange. Under an environment with high interest rates, likelihood of default increases for businesses as they are now required to pay huge amounts to their creditors (banks).

Moreover, the risk of default also increases as investors are now forced to pursue riskier projects in an attempt to earn higher
returns required for paying back the high interest bearing loans. Banks, anticipating this increase in the risk of default, keep the interest rates at the level which may not clear the market but maximise the banks’ profits. In other words, not everyone is able to get the loan even if one is willing to pay a higher price – credit rationing.

Higher interest rates coupled with other factors has resulted in a decline in gross capital formation (an investment indicator) from 22 per cent of GDP in 2008 to 15 per cent in 2010 (World Bank data). Economic Survey 2011-12 has shown private investment declining from 15 per cent of GDP in 2007-08 to 10.2 per cent in 2009-10. The provisional estimate for 2011-12 show that the private investment has further declined to 7.9 per cent of the GDP.

Despite excessive government borrowing, public investment has also failed to keep the investment demand stable and that, on the contrary, has declined from 5.4 per cent to three per cent over the same period. However, the World Bank estimates show that the gross savings rate has declined by less and has remained close 20 per cent of the GDP. With savings running ahead of investment, it is likely that the output growth will fall over the medium run if the trend in investment is not reversed with the help higher public investment and lower interest rates.

Having looked at the trends in inflation indexes and highlighted some of the costs associated with a high interest rate policy, I now return to the question under investigation – what is an optimal monetary policy? When the benefits of any policy are not clear while the costs associated with it are obvious, ‘caution’ becomes a virtue.

As long as the process of elimination of subsidies does not get completed and sufficient electricity is not produced to allow businesses to achieve economies of scale, it will not be appropriate to target a pre-crisis level of inflation rate. Additionally, an optimal monetary response to changes in inflation must adopt a cautionary approach if the underlying factors influencing the changes in price are supply or cost shocks.

First Published in Dawn (18th June 2012)

http://dawn.com/2012/06/18/tracking-inflation-for-optimal-monetary-policy/