The monetary policy is due next Monday. The committee, chaired by the SBP Governor, has already eased the policy rate by 900 bps (or 41 percent) over the last five reviews, as inflation nosedived. Real interest rates (irrespective of the lens used) remain well into positive territory. Economic growth is yet to revive, although there are some early signs of demand picking up.
The question is how much further easing is warranted without triggering pressure on balance of payments. It is imperative to maintain a delicate balance.
The impact of monetary easing or tightening on economic demand and, in turn, inflation comes with a lag—historically, it has taken 6–18 months in Pakistan. Remember, interest rates peaked in June 2023, and their impact on receding inflation and tapering money supply became visible from December 2023 onwards.
The easing cycle began in June 2024, and its effects are expected to materialize in the coming quarters. The SBP must adopt a careful and measured approach, as inflation has been highly volatile in recent years.
Published growth numbers (which come with a lag) show little sign of revival. GDP grew by 0.9 percent in 1QFY25, with the industrial sector contracting. In 5MFY25, Large-Scale Manufacturing (LSM) declined by 1.3 percent.
Interestingly, growth is primarily coming from export sectors—garments are up by 11.5 percent, and overall textile growth is positive. The bifurcation of exports and local markets is not demarcated in LSM data. Combining export and LSM data suggests that the domestic textile market is still shrinking, while exports are experiencing healthy growth.
Apart from automobiles and tobacco, there is hardly any growth in sectors catering to the domestic market. Automobile growth stems from a very low base (due to last year’s import restrictions), and in tobacco, the uptick is due to curbs on illicit trade.
The real estate market and construction sector remain sluggish. Within the services sector, the standout performer is information and communication technology (ICT), thanks to record-breaking ICT exports. Urban-related food and accommodation services are also showing some improvement, evident from fully occupied hotels and restaurants.
High-frequency data suggests signs of exuberance in the South. The standout performer is the stock market. The industry is mainly based in Karachi, which also hosts most retail investors. Additionally, the export-oriented industry dominates Karachi and its surrounding areas due to proximity to ports.
Demand in K-Electric’s jurisdiction has grown by 4–5 percent YoY in recent months, while the rest of the country (NTDC jurisdiction) lags. Similarly, real estate in Karachi’s DHA has seen an uptick, unlike Lahore and other northern and central cities.
The missing growth driver in the north is agriculture. Crops and agricultural processing industries are still struggling. The absence of wheat procurement prices, coupled with falling global commodity prices last year, has likely played a significant role in dampening demand and inflation.
Food prices collapsed, eroding growers’ incomes. Lower wheat prices and weak demand from the rural segment (as farmers refrained from spending on other goods and services) caused inflation to plummet and adversely affected crop sowing for the next season.
This implies lower domestic demand pressure on the balance of payments—evidenced by a $1.2 billion current account surplus in 1HFY25. This is a good sign, providing the SBP with confidence to further ease the policy rate.
However, the SBP must remain cognizant of the fact that monetary easing transmission occurs with a lag, and the impact of the 900bps easing will become visible in the coming quarters. As noted, early signs are emerging in urban areas, particularly in Karachi.
Excessive easing in a short time could trigger dollarization—especially with the dollar index strengthening and US treasury yields remaining sticky. The 3M T- Bill yield differential between Pakistan and the US is already three percent below its historical average. Foreign holdings of government securities (hot money) have dropped by $215 million in the last six weeks, undermining the SBP’s efforts to build forex reserves. These are warning signs that excessive easing could lead to currency depreciation and a resurgence of inflation.
The good news is that fiscal consolidation continues, and the government is on track to achieve a primary fiscal surplus for the second consecutive year. This provides the SBP with room for easing.
However, the SBP must allow time for the transmission of the 900bps easing to impact demand. Businesses in Karachi are already facing wage pressure, which could spread to other regions, potentially triggering a wage-price spiral and second-round inflationary effects.
In conclusion, a lack of domestic demand amid high real positive rates makes a case for further rate cuts. However, continuing an aggressive cutting stance is not advisable. The SBP could consider a 100bps cut, while a 200bps reduction cannot be entirely ruled out. The key element is to pause after another 200bps cut to observe the impact of reducing the policy rate by half.
Copyright Business Recorder, 2025
Ali Khizar is the Director of Research at Business Recorder. His Twitter handle is @AliKhizar
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