SBP Delivers Monstrous Rate Cut

250bps cut in policy rate is great news for the economy, but the central bank has some warnings in its statement as well.

The State Bank of Pakistan (SBP) surprised me this morning with a monstrous 250bps cut to the policy rate, which now stands at 15 percent. I was expecting a 200bps cut given that inflation has declined at a dramatically faster rate than expected. This development is great news for the broader economy: lower rates will reduce interest rate burden on the sovereign and also catalyze private sector lending activity.

However, there are some warnings within the statement issued by the central bank that merit a closer look.

Inflation is declining in part due to frozen energy prices.

This is what the statement says:

Moreover, a sharp decline in food inflation, favourable global oil prices and absence of expected adjustments in gas tariffs and PDL rates have accelerated the pace of disinflation in recent months.

We’ve all been here before.

The government of the day, facing political pressure and not eager to generate more negative headlines about rising energy prices, has stalled on the adjustment in prices for key energy inputs. With winter around the corner, the fact that these adjustments have not been made is a problem, as it may add to energy sector debt while also increase the likelihood of higher inflation once the adjustment has to be made.

Some of us argued that given the decline in international energy prices, the government should have collected higher taxes and kept prices stable, as that would be a fiscally prudent thing to do and also give the government a buffer to reduce tax collection if prices went up.

This has not happened, which means that higher inflation may be around the corner once the government decides to make the necessary adjustments. The only way out of this is to push through market reforms in the energy sector.

The government should not be in the business of setting prices for products, especially those whose prices are linked to international prices. The quicker energy markets reforms are pushed through, the better.

Tax collection is off track and may lead to IMF pressure.

In contrast, the FBR tax collection fell short of target during July-October. This implies that achieving the FY25 tax target will require significantly higher growth going forward…Meeting the targeted primary balance, however, would be challenging.

The SBP has said these types of things on numerous occasions in the past. Weak tax collection remains a major challenge for Pakistan, especially given the linkages between fiscal slippages and external sector volatility. The central bank is warning that while it continues to do its job in terms of combating inflation, the fiscal side has to play its part as well.

Given the politics of tax collection, all eyes will be on what happens in the second and third quarter of this fiscal year.

If the FBR fails to deliver on its end of the bargain, the IMF may start pushing harder on the government, forcing it to take near-term actions to achieve the agreed upon targets under the EFF.

There is also not enough juice left to squeeze out of those who are already taxed, especially formal businesses and salaried individuals. The government has to widen the tax base, but doing so is a politically problematic path for obvious reasons.

Agriculture output in some sectors is a cause of concern.

The initial estimates of major Kharif crops turned out better than the MPC’s earlier expectations. Higher-than-targeted estimates of rice and sugarcane production have more than offset the estimated shortfall in maize and cotton output.

Maize and cotton are critical crops for Pakistan, with the former used in the poultry supply-chain and the latter in the textile industry. Weaker output in these sectors is bad for farmers and may also create food inflation pressures (on the poultry side) and higher imports (on the cotton side).

Given that last year was also a problem year for farmers when it comes to wheat prices, sustained weakness in crops like maize and cotton is not great news. The government will have to find a way to deal with this issue if it is to manage the rural economy in the medium-term.

All of these issues are worth paying attention to, and the central bank is right is flagging these for those of us who monitor the economy. The burden of action, however, is on the government, not the central bank, and this is where politics intersects with the economy.

One hopes that the finance minister and the broader cabinet will pay attention to the central bank’s warnings, as dealing with them is critical to sustaining the stabilization of the economy.