With inflation easing, the State Bank of Pakistan (SBP) opted to pause its series of rate cuts, which could potentially cause currency instability or an expanding trade deficit.
Economists urged the government to prioritise economic reforms, emphasising that lowering interest rates alone is not a cure-all for growth. The central bank’s decision to maintain the policy rate at 12% on Monday came as a surprise to many analysts.
“The rate cuts alone may not meet growth targets,” said Vaqar Ahmed, economist and team lead with Oxford Policy Management. “They need to be complemented by prudent fiscal measures, such as tax reforms, energy sector viability and privatisation of state-owned enterprises, to encourage private sector investment and prevent crowding out.”
The central bank’s rate hold snapped the largest easing cycle in the country’s history, disappointing some businesses burdened by high borrowing costs.
Economists had expected a cut on Monday, following a series of cuts totalling 1,000 basis points from a record high of 22% in June last year to revive the economy.
The economy, which grew 0.9% in the first quarter, is expected to gain momentum for the rest of the fiscal year, according to central bank chief Jameel Ahmad. Though first-quarter growth is well below its 2.5%-3.5% target for the year, the economy is not stalling.
However, energy tariffs and the need for fiscal austerity measures under the International Monetary Fund programme pose significant challenges to reviving demand.
Most economists expect the central bank to resume cuts soon, either later this fiscal year or at the start of the next one despite concerns around the trade deficit and impact on the currency. The trade deficit in January increased 18% year on year to $2.313 billion.
The central bank is “likely to wait for more clarity on the external front or until they are confident about achieving their medium-term inflation target of 5-7%,” said Saad Hanif, head of research at Ismail Iqbal Securities.
“Once that happens, I expect them to resume rate cuts, though at a slower pace.”
Ehsan Malik, CEO of Pakistan Business Council (PBC), warned that cutting rates on Monday would have necessitated a reversal soon, as monetary easing raises imports and trade deficits, which put pressure on the exchange rate, fuelling inflation.
The cash-tight nation is navigating reforms under a $7 billion International Monetary Fund (IMF) programme approved in September. The first instalment of the loan is under review, and if successful, Pakistan will receive a tranche of $1 billion.
Revive demand and investments
Inflation soared to around 40% in May 2023, driven by currency devaluation and subsidy removals for IMF approvals. But inflation dropped to a near-decade low of 1.5% in February, providing room for the central bank to boost growth.
Economists also warn of the risk of the government taking advantage of lower interest rates to increase borrowing for an expansionary budget. That would potentially destabilise the progress made under the IMF programme and crowd out the private sector.
SBP reported government borrowing has rebounded, while private sector credit jumped 9.4% in the second quarter of the current fiscal year.
However, purchasing power constraints were expected to remain a deterrent to revived borrowing and investment.
“Consumer purchasing power will take time to recover from the 75%+ price surge between 2021-2024,” said Mustafa Pasha, executive director at Lakson Investments.
Asfandyar Farrukh, chairman of the Chainstore Association of Pakistan, said stagnant incomes and increased taxes have reduced consumer spending power.
Retail volumes of renowned brands fell 10-15% over the past year and a half, with “razor-thin profit margins” due to frequent discounts, he said, adding that medium and large retailers were consolidating to cope, or were shutting down, leaving only a few “deep-pocketed players” investing in growth.
High debt
Pakistan’s banking sector holds the world’s largest proportion of government securities relative to its total assets, according to an October 2024 IMF report.
The high domestic debt, mainly financed by banks, crowds out private sector credit, hindering policy transmission, reducing the impact of interest rate changes on the private sector, the IMF said in its report.
Reza Baqir, former SBP chief, stressed the importance of foreign exchange stability for sustaining economic growth in Pakistan, given its history of current account issues after periods of high consumption and import-led growth.
The country usually sets its budget for the year in June, with the fiscal new year running July 1 to June 30.
“Where there is fiscal dominance, there is relatively little that monetary policy will be able to do to prevent a current account deficit blow-out” if political or other developments lead to populist budgetary policies,” he warned.