Analysis: Why did SBP cut interest rates?

KARACHI: State Bank of Pakistan (SBP) unexpectedly cut its key policy rate by 50 basis points to 13.5 percent on Saturday, even as subsequent data showed that inflationary pressures are nowhere close to subsiding.

The move came out of the blue, startling market participants and economists who thought the State Bank of Pakistan would maintain its tight monetary policy until inflationary pressures go down. The bank raised the rate by 150 basis points in the first half of the 2010/11 fiscal year and held it at 14 percent in the second half, which ended June 30.

SBP expects the inflation rate to average around 12 percent in 2011/12, down from 13.9 percent in the previous year.

Data released on Tuesday shows annual inflation quickened to 13.77 percent in July, from 13.13 percent in June.

Here are some questions and answers about the country's inflation and policy responses:

ARE INFLATIONARY PRESSURES REALLY SUBSIDING?

While headline inflation may show some signs of moderation in the coming months, underlying price pressures remain strong.

Analysts say the government still needs to push through large increases in energy costs, especially on electricity and natural gas, to reduce its crippling subsidy bill.

Policymakers may be expecting some easing in headline numbers later in the year due to the high base effect as devastating floods pushed food prices sharply higher last year.

The main inflationary pressures in Pakistan come from food prices and oil prices. Food and beverages have 40 percent weightage in the consumer price index while fuel and transport together account for nearly 14 percent.

WAS THE SBP JUSTIFIED IN CUTTING RATES? WILL IT CUT AGAIN?

Given the risks to inflation and the external account, economists reckon there is little room for further easing, although one could argue that weakness in growth and investment were becoming equally big concerns.

Still, the SBP may have eased the rate a couple of months prematurely, as it is yet to be seen whether CPI falls below 13 percent on a sustainable basis.

Some analysts said the government benefits directly through lower funding costs -- through treasury bills and Pakistan Investment Bonds -- and note that the heavily leveraged corporate sector, reeling from the rise in borrowing costs, especially the state owned enterprises, could also win some respite.

The next policy move will depend on economic data over the coming two months but a further 50 basis point cut in September cannot be ruled out as weakening growth becomes the main policy-driver.

Analysts said that it would be difficult for the SBP to cut the policy rate below 13 percent. Also, inflation is expected to rise again in the second half of 2011/12 fiscal year because of the base effect.

HOW CAN INFLATION BE CONTROLLED?

Though much of the price pressure comes from external factors, the government can only actively combat inflation by taking fiscal measures to narrow the deficit -- raising revenue and cutting spending -- which will reduce the need to print money to finance it.

The situation could be helped by a fall in international oil prices, or by a bumper food crop globally or in Pakistan.

It can also be controlled through the tightening of monetary supply which would restrict money supply.

WHAT OTHER RISKS WORRY POLICYMAKERS?

Growth was anemic at just 2.4 percent in 2010/11 fiscal year, against the target of 4.5 percent because of devastating 2010 summer floods, which caused nearly $10 billion in damage.

Large scale manufacturing's growth was 1.7 percent from July 2010 through March 2011, as compared to the target of 4.9 percent mostly.

The trade deficit is also a big worry, on account of high crude prices and falling cotton prices.

The other big worry is the lack of external funding, which has helped keep the economy afloat.

The International Monetary Fund (IMF), which approved a $11 billion loan in November 2008 to avert a balance of payments crisis, held back the sixth tranche of the payment, citing the government's patchy implementation of fiscal reforms.

Last month, the U.S. confirmed it would defer $800 million to Pakistan -- nearly a third of its total annual security aid -- in part because Pakistan had expelled American military trainers and imposed limits on visas for U.S. personnel.

The absence of IMF funding and a lack of foreign direct investment will hammer Pakistan's foreign exchange reserves, especially when repayments to the IMF begin in 2012.