Monetary policy preview: Analysts divided on extent of interest rate cut

Most expect discount rate to be reduced by 100 basis points.

Reuters October 07, 2011


The central bank is due to announce its monetary policy for the subsequent two months today (Saturday). Analysts expect an interest rate cut of up to 100 basis points to 12.5 per cent due to lower inflation.

Although there is room to cut interest rates, some analysts also said a cut of 100 basis points to 12.5% might be premature and it is unclear whether the Consumer Price Index (CPI) can stay below 13% on a sustainable basis. The central bank could instead ease it by 50 basis points and adopt a wait-and-see policy, they said.

A rate cut theoretically should spur increased lending and therefore economic growth, but looming energy crisis poses an obstacle towards growth and undermines any boost to the economy.

The country is facing a gas shortage of nearly two billion cubic feet per day. That, combined with devastating summer floods in 2010 which caused nearly $10 billion in damages, has held growth to an anemic 2.4% in the 2010-11 fiscal year against a target of 4.5%.

What are the risks of lower interest rates?

The main risk of a cut in interest rates is further depreciation in the currency on higher lending and money supply. A weak rupee also makes it more expensive to repay foreign loans, a major concern for the debt-laden country.

Worse still, the country’s foreign exchange reserves could be hit by lack of external funding, especially as the government opted out of a new loan from the International Monetary Fund to extend one that ended on September 30.

There is also concern that foreign aid and international loans could dry up because of tensions in US-Pakistan relations. The absence of IMF funding and a lack of foreign direct investment will put added pressure on the current account.

How does fiscal deficit fit in?

It makes things tricky for the bank. The government’s fiscal deficit widened to 6.6% of gross domestic product for 2010-11, compared with earlier estimates of 5.3%. But massive energy subsidies are one of the reasons for the swelling deficit.

But if the government doesn’t cut subsidies, it will have to borrow more from domestic banks, which would fuel inflation again and further hammer the heavily leveraged corporate sector.

The high fiscal deficit, however, does not negate the effect of possible rate cuts as market yields are still low because the central bank keeps pumping in money through open market operations. 

Published in The Express Tribune, October 8th, 2011.


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