Pakistan’s unexpectedly large rate cut last week left analysts puzzled and concerned that the move, aimed at spurring growth, may end up widening the deficit and spurring inflation in the fragile economy.
Move counterproductive?
The central bank cut its key rate by 150 basis points to 12 per cent on Saturday, citing a decline in the inflation rate and government borrowing. State Bank of Pakistan (SBP) said it would meet its target of 12 per cent average inflation for fiscal year 2011/12. But analysts, who had expected a 50-100 basis point cut, worry that inflation has not been tamed on a sustainable basis, while money supply would increase as a result of this rate cut, the biggest in more than 10 years. “In our opinion, recent cuts in the policy rate point towards SBP shortsightedness,” Securities firm Arif Habib Ltd said in a note. “We think it would be counterproductive to allow the rates to ease that soon, allowing money supply to increase and feed sustained higher core inflation.” In fact, the biggest beneficiary of the rate cut could be the government, they say. A cut would ease some fiscal pressure in terms of debt servicing costs but that might be negated by depreciation in the rupee which would make it harder to repay foreign loans.
“We haven’t made up our minds whether or not it (inflation) is sustainable or not,” said Salem Ali, an economist at Standard Chartered Bank. “We do a see risk of inflation in 2012 with a probability of a rate hike as early as the second quarter of 2012 (April-June quarter).” In September, annual consumer inflation was 10.46 per cent, compared with 13.77 per cent in July, but the decline was mainly due to a high base effect which is expected to end by January. Month-on-month inflation has been accelerating at 1 per cent on an average, suggesting the threat is far from over. Ali expects inflation to jump to 13 per cent in January.GROWTH PANGS
Economic growth, the key driver for SBP’s latest move, may not benefit from the rate cut either, they say. Pakistan’s economy grew by an anemic 2.4 per cent in 2010/11. “Private sector investment is more constrained by poor law and order situation, political turmoil and energy crisis than higher interest rates,” Elixir Securities said. Pakistan has been marred by a Taliban insurgency in the country’s northwest and chronic power shortages. At least 400 people were killed in July and August in violence in the country’s main commercial hub, Karachi, as well. Another risk is a further depreciation in the currency on higher lending and money supply. A weak rupee will also make it more expensive to repay foreign loans, a major concern for debt-laden Pakistan. The rupee hit a record low of 87.92 last month and is trading at 87.48/52 to the dollar on Tuesday. If the rupee’s value depreciates then imports would become more expensive and debt repayments higher, which would lead to a drain in the country’s foreign exchange reserves and a further widening of the current account deficit.
Current account woes
Pakistan’s foreign exchange reserves fell to $17.35 billion in the week ending Oct. 1 from a record $18.31 billion in the week ending July 30, mainly because of debt repayments. A future lack of external funding, especially after the government opted out of a new loan from the International Monetary Fund to extend one that ended Sept. 30, will put added pressure on the current account. The current account deficit shrank to $189 million in the first two months of the fiscal year, July and August, from $1.016 billion a year earlier. In 2008, Pakistan and IMF agreed on a 3-year package loan for $11 billion. But the programme was halted in 2010 because of slow implementation of fiscal reforms, and only $8 billion had so far been disbursed. Islamabad has to start repaying the loan in early 2012 and that’s when the pressure on foreign exchange reserves will increase.
