The central bank usually uses inflation as its benchmark for the direction of its monetary policy. – (File Photo)

KARACHI: Pakistan's central bank is due to announce its monetary policy for the subsequent two months on Saturday. Analysts expect an interest rate cut of up to 100 basis points to 12.5 per cent due to lower inflation.

In July, the State Bank of Pakistan unexpectedly cut its key policy rate by 50 basis points to 13.5 per cent.

WHY DO ANALYSTS OVERWHELMING EXPECT A RATE CUT?

The central bank usually uses inflation as its benchmark for the direction of its monetary policy. Data has shown that consumer price index has been below 13 percent for the past two months which gives the central bank some room to cut interest rates again.

In September, annual consumer inflation was 10.46 per cent, compared with 11.56 per cent in August and 13.77 per cent in July, mainly due to a high base effect which is to last through December. Analysts expect inflation to rise to 13 per cent again in January.

However, even though annual consumer inflation has declined, over the past seven months, inflation has increased by an average of 1.1 per cent each month, indicating that underlying price pressures remain strong.

Also, the government still needs to cut its crippling energy subsidies, especially on electricity and natural gas, which will also have an inflationary impact.

Although there is room to cut interest rates, some analysts also said a cut of 100 basis points to 12.5 per cent might be premature, and it is unclear whether CPI can stay below 13 per cent on a sustainable basis.

The central bank could instead ease it by 50 basis points  and adopt a wait-and-see policy.

WILL A RATE CUT SPUR ECONOMIC GROWTH?

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

The country is facing a gas shortage of nearly 2.0 billion cubic feet per day. Total electricity demand in summer months outstrips supply by 22 per cent - or about 6,000 megawatts - during peak hours.

That, combined with devastating summer floods in 2010 which caused nearly $10 billion in damages, has held growth to an anemic 2.4 per cent in the 2010/11 fiscal year against a target of 4.5 per cent.

WHAT ARE THE RISKS OF LOWER INTEREST RATES?

The main risks 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 debt-laden Pakistan.

The rupee hit a record low of 87.92 last month and is currently trading at 87.22/27 to the dollar.

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 Sept. 30.

There is also concern that foreign aid and international loans could dry up because of tensions in US-Pakistan relations.

In 2008, Pakistan and IMF agreed on a 3-year package loan for $11 billion. But the programme was halted in 2010 because of slow implementation of fiscal reforms, and only $8 billion had so far been disbursed. Islamabad has to start repaying the loan in early 2012 and that's when the pressure on foreign exchange reserves will increase.

The country's foreign exchange reserves hit a record $18.31 billion in July and stood at $17.35 billion as of Oct. 1. That should cover five to six months of import payments.

According to official data, projected repayments during the year ending June 2012 to the IMF is $1.37 billion.

The absence of IMF funding and a lack of foreign direct investment will put added pressure on the current account.

The current account deficit shrank to $189 million in the first two months of the fiscal year, July and August, from  $1.016 billion a year earlier.

HOW DOES PAKISTAN'S FISCAL DEFICIT FIT IN?

It makes things tricky for the bank.

The government's fiscal deficit widened to 6.6 per cent of gross domestic product for 2010/11, compared with the earlier estimates of 5.3 per cent. It aims to contain the deficit at 4 per cent in the year ending June 30.

But massive energy subsidies are one of the reasons for the swelling deficit. Pakistan has so far shown little interest in cutting these as the IMF has demanded, especially with Senate elections coming up next year.

But if Pakistan doesn't cut the subsidies, the government will have to borrow more from domestic banks, which would fuel inflation again and further hammer the heavily leveraged corporate sector and state-owned enterprises.

The government also benefits directly from lower funding costs through treasury bills and Pakistan Investment Bonds.

All this has led to some speculation that any rate cut may be partly driven by government demands, wanting to reduce borrowing costs.