To cut or not to cut

Business Recorder

2 days ago

Recently, our business community has strongly advocated for lowering interest rates. While cheap credit is tempting for businesses, mistimed rate cuts can quickly turn problematic for the SBP. This brings us back to a question central bankers have long grappled with: to cut or not to cut?
Expectations for a significant rate cut have risen. Pakistan's policy rate currently stands at 11 percent, down from a peak of 22 percent in June 2024. The State Bank has already delivered 1,100 basis points of cuts in just over a year. Now, businesses are pressing for rates to drop to 5-6 percent, representing another 500 to 600 basis points reduction, bringing borrowing costs even lower than the 7 percent emergency levels during Covid-19.
This demand would be appealing if inflation hadn't surged following the recent petroleum price hike. Just as business leaders intensified their push for ultra-low rates, Pakistan's dependence on imported energy provided a sharp reality check. The government increased petrol prices by Rs8.36 per liter and diesel by Rs10.39 per liter from July 1st, lifting fuel costs to Rs272.98 and Rs266.79 per liter, respectively. This timing is especially troubling, as Pakistan's Sensitive Price Index jumped by 4.07 percent. Gas charges surged 29.85 percent, electricity by 21.46 percent, and even tomatoes increased by 22.93 percent due to higher transportation costs. Of 51 tracked items, 14 increased, while only 12 decreased.
Drastic rate cuts could quickly overheat the economy, yet the business community's requests aren't entirely unjustified. Pakistan's exports rely heavily on textiles; while Vietnam maintains rates at 6.3 percent, Indonesia at 6 percent, and India at 5.5 percent, Pakistan's 11 percent rate seems excessively harsh. For textile exporters operating on slim margins, a 5 percent difference significantly affects pricing competitiveness. The potential upside of sharp rate cuts appears immediately attractive. Auto financing has already demonstrated this; cutting rates from 22 percent to 11 percent sparked seven consecutive months of loan growth, with outstanding auto loans recently reaching Rs276.6 billion. Car sales surged 43 percent. If rates dropped another 5 or 6 percent, SBP's Rs3 million loan cap (which the industry wants to be raised to Rs6 million) would become irrelevant as credit accessibility expands dramatically.
Under favourable conditions, the government could benefit significantly. Following the recent budget, the government is strategically placed to benefit from any credit-driven boom. The 2025-26 budget abolished the 7 percent Federal Excise Duty on property transfers entirely and substantially reduced Islamabad's stamp duty from 4 percent to 1 percent. Lower taxes combined with cheaper credit could significantly boost transaction volumes, offsetting the tax cuts. In Punjab, KPK, and Balochistan, a rate cut would energize property transactions, each generating stamp duty revenue. Vehicle registrations would increase sharply, driving up fees and annual taxes. New digital transaction taxes would automatically capture growing e-commerce through payment gateways. Import volumes such as mobile phones, electronics, auto parts, and machinery would climb significantly, boosting customs revenues. Revived consumer spending would enhance sales tax collections. Business expansions would push more employees above taxable thresholds. The fiscal potential appears substantial when current revenues are multiplied by anticipated growth.
However, numbers alone don't reveal the full picture. Under the IMF programme, Pakistan can no longer subsidize energy prices. With energy-driven inflation rising, and it certainly would if rates fell to 5-6 percent, the government wouldn't have room to cushion the blow. Monetary policy then becomes our primary shield against inflation. Imagine businesses competing for workers, materials, and commercial space with cheap 5 percent loans. Households with easy borrowing power would chase cars, appliances, and homes. Our hard-earned USD 1.2 billion current account surplus would vanish as imports escalate. The rupee would weaken under mounting import pressure, pushing inflation higher. Pakistan has experienced this scenario before; brief periods of excitement followed by external crises demanding emergency rate hikes beyond 20 percent. Ironically, the businesses advocating for 5 percent rates today would suffer most when the inevitable adjustment arrives.
The dilemma faced by SMEs adds complexity. SMEs constitute 90 percent of businesses and provide 30 percent of jobs, yet receive only 6-7 percent of bank lending. They often pay 13 to 14 percent, while large corporations enjoy preferential rates. For SMEs, a drop from 11 percent to 6 percent could mean survival versus closure. Still, flooding SMEs with cheap credit while inflation accelerates could prove equally destructive; their customers lose purchasing power as input costs rise.
Most concerningly, aggressive rate cuts threaten our USD 7 billion IMF lifeline. The IMF programme sets explicit inflation and external account targets. Deviating from these goals for short-term stimulus would risk losing IMF support, other multilateral funding, credit rating downgrades, and potential financial collapse. Politicians understand these stakes but face immense electoral pressures. The political cycle creates powerful incentives for artificial growth stimulation. The SBP's independence is crucial; it must withstand political expediency and aggressive business lobbying.
What direction should the SBP take on July 30th? Neither paralysis nor wholesale surrender provides the solution. Comparing Pakistan with regional peers is easy on paper, but the realities differ significantly. With Pakistan under the IMF's 26th programme, our circumstances are distinctly different. Our regional peers have challenges of their own (tariffs, employment, inflation), but these differ greatly from ours. Further easing should rely on concrete evidence: sustained inflation below 5 percent, a continuous current account surplus, genuine export growth, and controlled import expansion. Businesses deserve encouragement, but alongside clear accountability.
This moment demands structural actions beyond merely adjusting interest rates. Businesses advocating 5 percent rates must support conditions enabling those low rates sustainably. Productivity must rise, exports must increase, import dependence must decline, and the informal economy must formalize. The SBP could channel lending toward productive sectors such as export-oriented industries, import substitution, technological upgrades; it should restrict credit for consumption and imports through targeted actions. Special Export Zones (SEZs) providing affordable credit for export-focused sectors represent an effective strategy. Broad, indiscriminate rate cuts represent a risky path, as previously detailed.
Offering cheaper refinancing options for exporters and SMEs while maintaining standard consumer loan rates can achieve a strategic balance. Though not perfect, targeted support is preferable to across-the-board reductions. The Rs3 million vehicle loan ceiling should remain unchanged despite industry pressures; Pakistan requires productive investments, not increased traffic and fuel imports. Direct credit toward expanding productive capacity rather than fuelling consumption.
Pakistan faces a critical decision point. Business frustration after enduring prolonged high interest rates is understandable, yet the solution proposed by businesses risks destabilizing the economy. Genuine progress demands patience, restraint, and fundamental reforms rather than quick rate cuts. The SBP must balance growth aspirations with stability requirements, navigating political pressures against economic realities. Interest rates are blunt instruments; careless handling within Pakistan's fragile economy resembles surgery with imprecise tools.
July 30th would be a decisive moment. Pakistan must choose between sustainable progress and another boom-bust cycle. Prudence, not impulsiveness, should guide this decision. The real question isn't just about reducing rates, but about creating conditions for sustainable low-interest growth. Until then, the SBP must act with caution, providing targeted relief while mitigating inflation risks.
Copyright Business Recorder, 2025