As the liquidity crunch hits Pakistan, the banks and other businesses are feeling the pinch. A liquidity crunch (also known as a credit crunch, credit squeeze or credit crisis) is a reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the banks. This liquidity crunch means that cash resources are in short supply and the demand for cash resources is high. Those businesses like banks that are involved in lending are highly vulnerable to default under these circumstances. But who exactly is to be blamed for this condition in Pakistan? Is it the fault of businesses and banks or is there some other subtler mechanism that’s causing this mess?
A genuine credit expansion is backed by real savings. When and if people’s time preferences change, meaning they don’t want to consume right now, but prefer to save for the future, these extra savings increases the funds available to the banks. This availability of funds genuinely lowers the interest rates in the market as the preference of people is to save, and banks are awash with the funds, and in no need to pay higher interest. This reduction in interest rates sends a signal to the businesses to opt for longer term projects. The projects that were initially not viable, when rates were higher, start looking more profitable with the reduction in rates. The lower cost of borrowing results in increasing the net present value of the projects. This leads to a growth in capital goods with a temporary decrease in consumer goods. These capital goods later allow for greater productivity and a general raising of the standard of living by increasing capacity and bringing more goods to the market.
Now compare the above to a scenario in which the State Bank of Pakistan intervenes to force the rates lower. This causes an artificial credit expansion as the bank increases the amount of money in the economy. This behavior sends the same signal to the businesses, alerting them to the availability of funds – funds that in reality haven’t actually been saved and as a result are not available. Only the lowering of the rates is making it appear as if they are. The businesses start engaging in projects that are longer term, in anticipation of greater consumption taking place in the future. The people though haven’t really changed their spending habits, and as a result continue to consume as before, instead of consuming less and saving more. Therein lies the problem: There are not enough resources (funds) available for the longer term projects, as is falsely signaled by the lowering of the rates by the state bank. Not only is the consumption not reduced, but the saving has also not increased. There is an illusion of prosperity and growth as consumer goods and the producer goods are both in demand. The consumer goods because people never curtailed their consumption, and producer goods because businesses are now incorrectly undertaking longer term projects because of lower rates.
As the credit expansion continues, more and more businesses vie for the ever dwindling resources. This forces the prices of production resources to rise, including the cost of labor and materials. This euphoric phase has in general lower unemployment, higher salaries, and a weaker standards of lending. As the credit (and monetary base of currency) increases, and there isn’t much change in demand for money, price inflation starts creeping into the economy. Price inflation makes the prices of almost all goods go up. These rising costs start worrying the state bank, and to curb this inflation the state bank starts reducing the monetary base. By slowing down the expansion of credit and the growth of monetary expansion it tries to contain the boom from going too far. Selling bonds in the open market and by raising the overnight lending rates the state bank starts curbing the overabundance of liquidity in the market.
This slowing down of credit expansion by the state bank reduces the availability of loanable funds. Not having enough funds or resources means that not every business can complete all the projects that were undertaken. Realizing the precarious situation of the businesses, the lenders scramble to recover their loans, and are not willing to lend out more due to the danger of the businesses going under. Business on the other hand scramble to halt their projects once they realize that they their assumptions and forecasts were grossly incorrect. Credit crunch, liquidity crunch, or bursting of the economic bubble are all the result of this sudden realization that the house of cards is about to crumble. The demand to protect the funds increases and the willingness to lend decreases sharply. This leads to a disappearance of the funds from the market, causing bad businesses and those with lower margins and higher leverage to start going bankrupt. The party has come to an end. Liquidity crunch has hit Pakistan. Think of it as a builder of a house realizing midway that there are not enough bricks available in the entire market to finish the job! The longer it takes the builder to realize that there weren’t enough bricks, the greater is the cost. The earlier the mistake is realized the earlier and at a lower cost plans could be altered to design a house with the appropriate bricks.
The analysis highlights the result of the direct involvement of the State Bank of Pakistan in causing malinvestments and the boom and bust business cycles. It is the monetary policy of the state bank that leads to unsustainable business growth, and eventually to a crash. The irony is not that the boom and bust took place. The real irony is that businesses wasted so many resources in malinvestments; resources that could have been used in productive enterprises, resulting in genuine growth and prosperity via the creation of capital goods. The banking sector now is facing another credit and liquidity crunch, and what do you suppose is the reaction of the State Bank of Pakistan to deal with the situation? Of course it will be the same old, credit expansion, leading to malinvestments, and eventually to bigger economic problems down the road.