Benefits of lower interest rates and fuel prices

Central banks around the world have slashed interest rates, though perhaps none as aggressively as State Bank of Pakistan (SBP). According to a recent report by Bloomberg, Pakistan has cut its interest rates the most this year, out of a survey of nine countries, including the US, Peru, South Africa, Turkey and Ukraine. Coronavirus has created ‘unique’ challenges for a monetary policy due to its non-economic origin. In last three months, SBP has slashed the policy rate four times. In the space between March 17 and May 15, the SBP has cut the policy rate by a whopping 525 basis points, from the relatively high 13.25% to 8%.

While SBP acknowledges that easier monetary policy can neither affect the rate of infection transmission nor prevent the near-term fall in economic activity due to lockdowns, it can provide liquidity support to households and businesses to help them through the ensuing temporary phase of economic disruption. The SBP also maintained that the rapid policy rate cuts had helped maintain credit flows and bolstered cash flow of borrowers, thereby limiting contraction in the economy.

Inflation expectations

According to the SBP, inflation could fall closer to the lower end of the previously announced ranges of 11-12 percent this fiscal year and 7-9 percent next fiscal year. In January 2020, the inflation rate had hit a record 14.56%, according to data released by the Pakistan Bureau of Statistics (PBS). However, it has been declining since, slowing to 12.4% in February, and then to 10.24% in March, finally settling at 8.5% in April. Many analysts expect it to drop to 8% or 7% in the coming months.

For its part, SBP said that the significantly reduced petrol and diesel prices by 30-40%, in response to the continued fall in global oil prices, will further reduce inflation. It also said that both the fall in inflation in Pakistan since January and the expected further decline next year are the highest among comparable emerging markets.

However, inflation could fall further than expected if economic activity fails to pick up as expected next fiscal year. On the other hand, there are some upside risks from potential food-price shocks associated with adverse agricultural conditions due to locust attacks. Price pressures could also emerge if the economy gains greater momentum in the second half of FY21.

Outlook for Pakistan

Exports have declined by 10.8% YoY in March, while imports contracted by 19.3% YoY. The figures were even worse in April, with exports declining 54% YoY, and imports declining 32% YoY. However, the current account deficit had continued to narrow, and that the outlook for the external sector broadly remains stable.

The recent fall in portfolio inflows will be offset by official flows committed by the international community, such that Pakistan’s external position remains fully funded. Together, these developments, supported by the flexible exchange rate regime, should continue to support a steady build up in the SBP’s foreign exchange reserve buffers. The remittances though resilient have certain potential downside risks, given the economic difficulties across the world, especially in oil-exporting countries. On the fiscal front, the primary balance recorded a surplus of 0.4% of GDP from July to March FY20, against a deficit of 1.2%  in the same period of FY19. This is the first nine-month surplus since FY16.

However, the substantial fall in economic activity since March significantly affected tax revenues. After rising by 17.5% from July to February FY20, tax revenues declined sharply by 15% in both March and April. Given the needed increase in spending to support healthcare, businesses, households and more vulnerable segments of society, the fiscal deficit is expected to widen substantially in Q4. Large scale manufacturing witnessed a steep decline of 23% in March, due to the virus. Meanwhile, high-frequency indicators of demand such as credit card spending, cement dispatches, credit off-take and POL sales showed contraction in domestic economic activity in both March and April.

Despite previous interest rate cuts of March and April, many analysts and businessmen feel that SBP should reduce the policy rate even further to as low as 5% in light of the global pandemic, and falling inflation. They are of the opinion that if SBP wants the economy and demand to pick up gradually, lowering the discount rate was necessary. Lowering of interest rate at 5 percent together with cheaper oil import shall raise future expectations of investors and serve as vantage point for Pakistan in steadily conquering the budding trade gap in GSP Plus backed markets of Europe. Moreover, it would also make business climate more lucrative for foreign investment in the ongoing pandemic.