Explainer: How falling interest rates affect the real economy

As Pakistan's economic outlook finally started to improve this year, analysts and industrialists' started looking even more closely at the country's central bank, especially its Monetary Policy Committee that decides the benchmark interest rate.

Raised to 22% in 2023, the interest rate was at a record high, and while its effect on taming inflation was being hotly debated, its effect on the country's real economy was the real concern. This is why when the State Bank of Pakistan (SBP) finally kickstarted the monetary easing cycle this June, the industry collectively breathed a sigh of relief.

Since then, the SBP has been on a roll. In four consecutive meetings of the Monetary Policy Committee, it has reduced the interest rate by a cumulative 700 basis points (bps) to 15%. The market widely expects another cut at the MPC's December 16 meeting.

But have all these cuts been beneficial for the real economy? Nukta looked at the data and reached out to analysts to explain the effect falling interest rates have on the real economy and why Pakistan's case may be slightly different.

But first, in case you were confused about what the real economy is, it's the part of the economy that's related to goods and services rather than banks and stock markets.

What happens when rates fall?

When interest rates fall, they affect industries — the drivers of the real economy — in multiple ways.

"Falling interest rates typically lower borrowing costs, encouraging businesses to invest and consumers to spend, boosting economic activity," Iffat Zehra Mankani, CEO JS Investments, explained.

"Sectors like auto, construction (cement & steel) and leveraged sectors too such as pharma and textiles benefit the most."

Muhammad Awais Ashraf, head of research at AKD Securities, agreed. "Reducing financing costs will further reduce the cost of doing business and have positive impact on growth and inflation. Cheaper financing will affect trading and cyclical sectors most," he commented.

Meanwhile, Maaz Azam, head of research at Optimus Capital, said falling rates would help struggling sectors, which include mainly textile, steel, other construction-allied industries, auto parts manufacturers etc.

There would also be a trickle-down effect on smaller industries in the supply chain, he added.

So, what does this all mean? Simply put, falling interest rates make borrowing less expensive. This makes it easier for companies to take out loans and invest in expansion and upgradation, increasing profits and creating more jobs.

For companies that have outstanding loans, they reduce the cost of doing business since companies now have to pay back a lesser amount, which has a positive impact on the growth of the real economy.

The cheaper borrowing rates also make it more likely that people will take loans for products such as homes, cars, and home appliances — and just generally spend more — driving consumption and stimulating the real economy.

What's up with Pakistan?

While Pakistan's central bank has cut interest rates by seven percentage points since June, the effect on the real economy has not been as significant as might have been expected.

Cement sales have picked up only in the last two months, large-scale manufacturing actually declined in the first quarter of this fiscal year, and while auto sales are up, they're far from where they were years ago. For context, in 10 months of 2024, 81,000 cars have been sold. During the same period in 2022, 183,000 cars were sold — more than double.

So, why are falling interest rates not having the intended effect quickly? The answer has a lot to do with Pakistan's economic situation, which has only started to improve in recent months. Its inflation, which reached a record high of 38% last year, has eroded people's purchasing power, which has resulted in lower demand.

Moreover, the government has raised electricity rates sharply over the last year in an attempt to reduce its circular debt, which has made it the biggest expense for households and raised the cost of production for industries, thus, also reducing demand.

A Bloomberg report published earlier this year found that for some Pakistanis, electricity bills are even more expensive than the house rent they pay.

This affects demand in various ways — it becomes more expensive for companies to produce items (and consumers to purchase them) and people's priorities change as they focus on spending only on essentials, hitting industries and the real economy.

This might explain why industrial activity isn't picking up despite a rise in electricity generation since the start of the monetary easing cycle.

So, while falling interest rates do benefit the economy, in Pakistan, they will continue to have a limited effect as long as the cost of production remains high and people’s purchasing power remains low.