The monetary policy is due on Monday (4th November). The pulse of the Chundrigar road is a 200-bps cut to a 15.5 percent policy rate. Given the macroeconomic conditions and political pressures from Islamabad, that outcome seems likely. However, considering the balance of payment risks, a more prudent approach could involve reducing the rate by 150 basis points to 16 percent.
Contrary to the expectations of stock market pundits, who are ecstatic about inflation falling to 7 percent, we expect the next 12-month average to be between 7 and 8 percent. It is important to remember that in the recent past, real rates were significantly negative, which contributed to the unprecedented inflation of the last two years.
The monetary policy committee’s aim should be to reach a 5-7 percent inflation medium-term target by October 2025. Do not keep on having a moving target. As inflation begins to decline, the SBP should maintain a firm grip on the target. And that can only happen by keeping real rates significantly higher.
The good news is that open market operations (OMOs) injection is sharply down from the peak of Rs13.0 trillion in the first week of September to Rs9.3 trillion as of now. The fall is due to the improved cash flow position of the Ministry of Finance, which got Rs2.7 trillion in SBP profits and some external inflows. This has led to the repurchase of T-Bills and the cancellation of several auctions.
However, the OMO toll may increase after December due to the upcoming lumpy maturities, and the government may require additional injections to finance its deficit. The expected fiscal deficit is Rs7 trillion in FY25, and not all could be financed by the system liquidity, as there is some uptick in the private credit as well.
To prevent OMOs from increasing significantly, the State Bank of Pakistan (SBP) and the Ministry of Finance should explore alternative financing options, primarily from foreign sources. This is one way to increase foreigners’ investment in T-Bills, also known as hot money, whose outstanding amount has surpassed $800 million. More is needed. We need to set higher real rates to attract their interest. And if the rate cut is aggressive, the existing toll could fall sharply.
In general, banks tend to avoid using OMO if the difference between policy rates and T-bills becomes excessively high. The secondary market yield of 3-M paper is below 14 percent, while the policy rate is at 17.5 percent. They both should converge—one to come down and the other to rise—to have equilibrium.
That is why perhaps the government raised Rs716 billion in the last T-Bill auction as against the target of Rs400 billion at a time when the government had cash in hand. If the government had accepted the lower amount, the yields could have been even lower than the 3M cutoff at 15.3 percent.
The IMF report suggests that SBP should gradually be easing. The country benefits because inflation is not the only indicator. Fiscal, external, and growth are the other three parameters. A tight fiscal policy with a second consecutive year of primary surplus is encouraging. And at the same time, a low growth outlook should be a worry. Lower interest rates certainly would help growth.
However, having growth beyond 3 percent can put the current account under pressure due to increased imports. Given that the reserves held by the SBP cover 2.5 months’ worth of imports, the country cannot afford to run a current account deficit. That is why SBP is not doing away with its restrictions on auto loans, which are capped at Rs3 million.
If imports increase, this could exert pressure on the currency, potentially causing a ripple effect—remember, memories of 2022 and 2023 are still fresh. Thus, considering the external account pressure, SBP should gradually bring the rates down.
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