What was behind Pakistan central bank's decision to cut the interest rate this time?

When Pakistan's central bank announced a cut in the key policy rate on December 16, the move was entirely expected. In fact, the only debate among analysts and economists had been over the extent of the cut.

Most of them had expected a 200 basis points (bps) cut — as decided by the State Bank of Pakistan's Monetary Policy Committee — while a few had projected a 250-bps reduction. Meanwhile, industrialists had been urging the SBP to bring the interest rate down to below 10% (compared to the 13% after the latest cut).

The central bank started the monetary easing cycle in June, cutting the rate by 100bps from a record 22% where it had been for a year. Since then, it has reduced the rate by a cumulative 900bps — the highest-ever rate cut in a year.

So, what's behind the SBP's expansionary stance and especially, its reasoning behind the latest cut?

Reduced inflation

The headline inflation measured using the Consumer Price Index fell sharply to 4.9% in November compared to the same month in the preceding year — touching a 6.5 year low when it was recorded at 4.2% in May 2018.

The deflationary trend witnessed in the food group, along with a slowdown in inflationary pressure in the housing group, led to a sharp decline in national inflation. The average inflation for Jul-Nov (5MFY25) is 7.94%, which is lower than the 28.63% recorded in the same period last year. This was attributed to the favorable base effect from gas prices, stable global commodity prices, and controlled food inflation.

However, core inflation remained sticky at 9.7% with core-urban at 8.9% (down 52.2% YoY) and core-rural at 10.9% (down 57.9% YoY), indicating that the favorable impacts of the base are starting to materialize. The SBP will keep a check on core inflation over the next few months. As the base effect fades, inflation is likely to rise again, prompting the central bank to adopt a cautious stance.

Nukta research anticipates December inflation to clock in at 3.98% marking the lowest inflation reading in 80 months. The last time inflation was lower was in April 2018 when it was measured at 3.68%. This will bring the real interest rate down to 9%.

Improving current account & remittances

Pakistan recorded a current account surplus of $729 million in November, the highest in almost a decade since a surplus of $801 million in February 2015. This was primarily attributable to a reduction in imports (down 9%), a rise in exports (up 3%) and improved remittances (up 29%).

The country incurred a cumulative current account surplus of $947 million in 5MFY25, compared to the deficit of $1.8 billion recorded in 5MFY24. This was also reiterated by the governor in the analyst briefing.

Workers' remittances improved by 29% YoY, reaching a total of $2.9 billion in November compared to $2.3 billion in November 2023. The highest amount came in from Saudi Arabia ($729 million), followed by the UAE ($619 million), and the UK ($410 million).

The rise in remittances comes as people shift to official channels for sending money following a widespread crackdown on illegal forex trading and smuggling and wide-ranging reforms by the central bank for exchange companies.

The stabilization of the kerb premium, an influx of workers to countries like Saudi Arabia and the UAE, and increased reliance on remittances to fund domestic demand are expected to lead to an improvement in remittances going forward.

Fiscal consolidation for tax collection

Pakistan's fiscal stance is counterproductive, amplifying economic fluctuations rather than stabilizing growth. A significant risk to the economy and inflation expectations is a potential revenue shortfall, requiring measures to increase government revenue, such as taxing the agriculture sector and wholesale & retail trade under the services sector.

Pakistan's tax collection authority — the Federal Board of Revenue (FBR) — collected PKR 4.3 trillion in tax revenue during the first five months of fiscal year 2024-25 (FY25), a growth of 23% year-on-year. However, the revenue was short of the target of PKR 4.6 trillion by a huge PKR 356 billion.

Achieving of the fiscal target

While falling interest rates will save the government PKR 1.5-2 trillion in interest payments, the FBR's revenue target remains challenging, and even with these savings, a shortfall of PKR 2 trillion is likely.

If monetary easing continues, the current savings of PKR 2 trillion could increase to PKR 2.5 trillion, potentially helping the government achieve its fiscal target. To note, the interest expense target for FY25 was PKR 9.8 trillion, keeping in mind the policy rate range of 17-18%, but due to a historical reduction in the interest rate of 9%, the government now expects the expense to be around PKR 8 trillion.

Repayment of external debt not worrisome

The total payment obligations for FY25 stand at $26.1 billion. This repayment includes both the principal loans ($22.1 billion) and interest payments ($4 billion). Of this, the country has either paid or rolled over an amount of $10.4 billion.

Pakistan has to repay foreign debt amounting to $5 billion by June 2025, which excludes rollovers. During the analyst briefing following the announcement of the new policy rate, SBP Governor Jameel Ahmed said that there is no pressure to service the debt, as anticipated financial inflows of $2 billion in the coming quarter, along with repayments near $2 billion, result in a balanced inflow and outflow, easing the pressure on reserves.

Pakistan recently received inflows from the Asian Development Bank amounting to $500 million and $320 million for disaster resilience and infrastructural development, respectively.

Foreign reserves to exceed $13 billion

With the International Monetary Fund (IMF) review of the Extended Fund Facility expected by end 3QFY25, the SBP has set a target of increasing foreign exchange reserves to above $13 billion by the end of June 2025, up from the current target of $12 billion.

Improved prospects for real GDP growth

For FY25, the real GDP growth is projected to remain in the upper half of the projected range of 2.5% to 3.5%.

The major driver would be the agriculture sector — which contributed 6.8% in 4QFY24 in bringing the inflation down — as the downside risks to crops have subsided.

The risks that still persist

As the cumulative easing measures in place since mid-2024 start to produce noticeable effects, the rate drop represents a critical step in preserving macroeconomic stability and fostering growth.

Risks still exist, though, and these include the phasing out of the base effect, rising global commodity prices, a return to high food inflation, and efforts to address income gaps.