MPC should hold the line

The monetary policy is expected to be announced next week. The State Bank of Pakistan (SBP) has already slashed interest rates by half from their peak to 11 percent. Yet, monetary transmission remains elusive.

Aggregate demand is still sluggish, as evidenced by low GDP growth and lagging private sector credit. Inflation shows no signs of a significant upsurge. Based on these factors, there may still be room for another 100 to 200 basis points cut before hitting the policy floor.

The question is not just if the SBP should cut rates but how fast it should move. The main concern is external account slippage and its implications for the currency and, in turn, inflation. There is a delicate interplay between exchange rate management and the interest rate path.

Already, the currency is under pressure, and the dollar is perceived to be in short supply in the interbank market. This calls for a cautious approach by the Monetary Policy Committee.

One key indicator is the differential between US and Pakistani treasury bill/bond yields, which has a direct impact on foreign currency liquidity. Currently, the Pakistan–US treasury yield spread stands at 6.6 percent below the 20-year average of 8.1 percent. Historically, when the differential has dropped below this average as in 2002-07, 2014-18, and 2022-24 it has been followed by steep currency depreciation and sharp interest rate hikes.

The SBP must learn from the past and avoid another boom-bust cycle in pursuit of short-lived GDP growth spurts. The central bank’s primary focus should be to maintain inflation within its target band of 5–7 percent. For that, currency stability is essential. It must not allow the current pressure on the rupee to spiral into panic.

External account management remains critical. So far, the SBP has done well. It has likely purchased $12–14 billion from the interbank market over the past 18 months — an impressive feat that has helped build foreign exchange reserves and reduce forward liabilities without increasing external debt.

Whatever playbook the SBP is following, it must stick to it in FY26. There is no room for complacency. External debt servicing requirements in FY26 stand at around $26 billion, and the gross financing need is approximately US$10 billion to reach the IMF’s reserve target of $17 billion by the end of the fiscal year.

The macro story remains largely unchanged from last year—and so should the management strategy, with a focus on keeping the current account in check. Imports are already hovering around $60 billion, despite GDP growth of just 2.5 percent. These are bound to rise this year, even with current interest rates.

Remittances, meanwhile, may not maintain their recent growth from a high base. Moreover, uncertainty over the subsidy mechanism to encourage formal remittance flows could further constrain growth in this area. On the export side, performance is already struggling to hold current levels.

Given this outlook, the SBP cannot afford to let imports run unchecked. It may need to continue monitoring and policing commercial banks’ treasury operations, ensuring that outflows are matched by inflows. Keeping real interest rates elevated makes this task easier for bankers and reduces speculative pressure on the rupee.

However, market expectations diverge. Both equity sentiment and money market yields indicate that a 50 to100 basis point cut is already priced in. There is political pressure as well—both from the government and other quarters—for the SBP to lower rates. The argument is that doing so would jumpstart growth and revive asset classes like real estate. But, so far, these sectors have not responded meaningfully to lower interest rates.

Even further rate cuts may not trigger growth. Firms are deterred by other hurdles: high energy costs, systemic inefficiencies, and abnormally high taxation. Interest rates are not the sole bottleneck. Yet a premature cut could fuel pressure on the rupee—and heighten the risk of dollarization. Already, foreign currency is scarce in the open market, and import settlement rates in the interbank market are higher than the SBP’s official rate.

Signs of market anxiety are building. These need to be managed carefully to preserve macroeconomic stability.

The real debate within the Monetary Policy Committee will be whether to maintain the status quo or opt for a token 50 basis point cut. One factor that supports holding rates steady is international oil prices, which are hovering around $70 per barrel. Any sustained increase could translate into higher domestic fuel prices, posing upside risks to inflation. The SBP should keep a close watch on this.

Finally, lower interest rates tend to push liquidity into riskier asset classes. Beyond the stock market, funds are flowing into commodities—evidenced by the recent surge in sugar prices. A similar trend could emerge in wheat, which would undermine the SBP’s inflation target. The doctor’s order, then, is clear: sustain the pressure, and maintain a status quo.

Copyright Business Recorder, 2025